Timothy Blixseth v. Stephen Brown, et al

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FILED OPINION (ALEX KOZINSKI, RICHARD A. PAEZ and MARSHA S. BERZON) AFFIRMED IN PART; VACATED IN PART; REMANDED IN PART. The parties shall bear their own costs. Judge: AK Authoring. FILED AND ENTERED JUDGMENT. [10211115]

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Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 1 of 402 16 1, 20 ber 2 vem n No ed o rchiv 63 a -353 . 14 , No rown .B eth v Blixs AMERICAN B A N K R U P TC Y INSTITUTE in cited CO M M I S S I O N D.J. Baker James E. Millstein Donald S. Bernstein Harold S. Novikoff William A. Brandt, Jr. James P. Seery, Jr. Jack Butler Sheila T. Smith Babette A. Ceccotti James H.M. Sprayregen Hon. Arthur J. Gonzalez Albert Togut, Co-chair Steven M. Hedberg Clifford J. White III Robert J. Keach, Co-chair Bettina M. Whyte Prof. Kenneth N. Klee Deborah D. Williamson Richard B. Levin Geoffrey L. Berman FINAL REPORT AND RECOMMENDATIONS Harvey R. Miller James T. Markus SPONSORED BY THE ANTHONY H.N. SCHNELLING ENDOWMENT FUND Reporter: Prof. Michelle M. Harner TO S T U DY T H E R E F O R M OF CHAPTER 11 2012~2014 Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 2 of 402 American Bankruptcy Institute Copyright © 2014 by the American Bankruptcy Institute. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the publisher and copyright holder. Printed in the United States of America. “This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting or other professional services. If legal advice or other expert assistance is required, the services of a competent professional person should be sought.” — From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers and Associations. ISBN: 978-1-937651-84-8 Additional copies may be purchased from the American Bankruptcy Institute. Discounts are available to ABI members. Copies also may be purchased at ABI’s website, ABI World, www.abiworld.org. Founded on Capitol Hill in 1982, the American Bankruptcy Institute (ABI) is the only multidisciplinary, nonpartisan organization devoted to the advancement of jurisprudence related to 16 1, 20 ber 2 problems of insolvency. The ABI membership includes more than 13,000 attorneys, bankers, judges, m Nove d on accountants, professors, turnaround specialists and othervebankruptcy professionals, providing i arch a forum for the exchange of ideas and information.63 -353 ABI was founded to provide Congress with . 14 , No unbiased testimony and research on insolvency issues. For further information, contact ABI. rown B h v. xset n Bli i cited ii Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 3 of 402 ABI Commission to Study the Reform of Chapter  Table of Contents I. Introduction ..................................................................................................................................... II. Executive Summary of Proposed Principles ............................................................... III. Background on the Commission and the Study Project ................................... A. Brief History of U.S. Business Reorganization Laws................................................................ B. The Need for Reform .................................................................................................................... C. The Commission’s Study................................................................................................................ D. The Commission’s Deliberations ................................................................................................ IV. Proposed Recommendations: Commencing the Case .......................................... A. Oversight of the Case ................................................................................................................. . The Debtor in Possession Model ................................................................................................................  . The Chapter  Trustee .................................................................................................................................  . The Estate Neutral.........................................................................................................................................  16 . Statutory Committees ...................................................................................................................................  1, 20 ber 2 vem . Estate Fiduciaries............................................................................................................................................  n No ed o rchiv . Valuation Information Packages ...............................................................................................................  63 a -353 . 14 . Professionals and Compensation Issues ..................................................................................................  , No rown B h v. . Costs in Chapter t Cases ............................................................................................................................  xse n Bli i cited B. Financing the Case ........................................................................................................................ . Adequate Protection .....................................................................................................................................  . Terms of Postpetition Financing ...............................................................................................................  C. Breathing Spell for Debtor upon Filing .................................................................................. . Timing of Approval of Certain Postpetition Financing Provisions ..............................................  . Timing of Section x Sales .......................................................................................................................  D. Payment of Certain Claims upon Filing.................................................................................... . Prepetition Claims and the Doctrine of Necessity............................................................................  . Wage and Benefits Priorities ......................................................................................................................  E. Financial Contracts, Derivatives and Safe Harbor Provisions .......................................... . Scope of Section (e) Safe Harbors.......................................................................................................  . Treatment of Repurchase Agreements Under Safe Harbors ...........................................................  . Assumption of Financial Contracts....................................................................................................... . Section  and “Commercially Reasonable Determinants of Value” ....................................... . Walkaway Clauses ........................................................................................................................................ . Exclusion of “Ordinary Supply Contracts” from Safe Harbors................................................... iii Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 4 of 402 American Bankruptcy Institute V. Proposed Recommendations: Administering the Case ...................................... A. Executory Contracts and Leases ............................................................................................ . Definition of Executory Contract ........................................................................................................ . General Rights of Private Parties to Executory Contracts and Unexpired Leases ............ . Rejection of Executory Contracts and Unexpired Leases............................................................. . Intellectual Property Licenses ............................................................................................................... . Trademark Licenses ...................................................................................................................................... . Real Property Leases ................................................................................................................................... B. Use, Sale, or Lease of Property of the Estate ....................................................................... . General Provisions for Non-Ordinary Course Transactions ...................................................... . Finality of Orders ........................................................................................................................................ . Transactions Free and Clear of Interests........................................................................................... . Credit Bidding ................................................................................................................................................ C. Avoiding Powers .......................................................................................................................... . Preference Claims......................................................................................................................................... . Recoveries Under Section  ................................................................................................................... D. Labor and Benefits ..................................................................................................................... . Collective Bargaining Agreements Under Section  ................................................................ 16 1, 20 ber 2 . Retiree Benefits and Section  ........................................................................................................... vem n No ed o E. Administrative Claims ............................................................................................................... rchiv 63 a -353 . 14 . Section (b)() and Reclamation ......................................................................................................... , No rown B . Administrative Claims h v. xset Committee ......................................................................................................... n Bli i c ted . WARN Act iClaims .......................................................................................................................................... . Severance Benefits ....................................................................................................................................... F. General Valuation Standards ................................................................................................... G. Standard for Reviewing Settlements and Compromises .................................................... H. The In Pari Delicto Doctrine ................................................................................................... VI. Proposed Recommendations: Exiting the Case ................................................... A. General Authority of Debtor in Possession and Its Board of Directors....................... . Preemption and the Authority to Approve Transactions and Plan ......................................... . Role of Debtor in Plan Process ............................................................................................................... B. Approval of Section x Sales ................................................................................................ C. Value Determinations, Allocation, and Distributions ...................................................... . Creditors’ Rights to Reorganization Value and Redemption Option Value .......................... . New Value Corollary .................................................................................................................................. . Section (c) and Charges Against Collateral .............................................................................. . Section (b) and Equities of the Case ................................................................................................ . Cramdown Interest Rates .......................................................................................................................... . Class-Skipping and Intra-Class Discriminating Distributions .................................................... iv Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 5 of 402 ABI Commission to Study the Reform of Chapter  D. Disclosure and Use of Postconfirmation Entities and Claims Trading ......................... E. General Plan Content ............................................................................................................... . Default Plan Treatment Provisions ....................................................................................................... . Exculpatory Clauses .................................................................................................................................... . Third-Party Releases .................................................................................................................................. F. Plan Voting and Confirmation Issues ..................................................................................... . Class Acceptance Generally and for Cramdown Purposes........................................................... . Assignment of Voting Rights .................................................................................................................... . Designation of Votes.................................................................................................................................... . Settlements and Compromises in Plan .................................................................................................. . Discharge of Claims upon Confirmation ............................................................................................. G. Orders Resolving Chapter  Case (Exit Orders) ................................................................ VII. Proposed Recommendations: Small and Medium-Sized Enterprise (SME) Cases ................................................................................................................................ A. Definition of SME ....................................................................................................................... B. General Application of SME Principles.................................................................................. C. Oversight of SME Cases............................................................................................................. 6 , 201 D. Plan Timeline in SME Cases ....................................................................................................... er 21 emb Nov d on E. Plan Content and Confirmation in SME Casesi..................................................................... ch ve VIII. 3 ar 3536 . 14, No Proposed Recommendations: Standard of Review own v. Br eth Blixs and KeyitDefinitions ........................................................................................................... ed in c A. General Standard of Review .................................................................................................... B. Key Definitions and Concepts in Principles .......................................................................... IX. Other Issues Relating to Chapter  Cases .......................................................... A. Venue of Chapter  Cases ........................................................................................................ B. Core and Noncore Matters in Chapter  Cases .................................................................. C. Individual Chapter  Cases ..................................................................................................... D. SIFIs and Single Point of Entry Schemes ................................................................................ E. Cross-Border Cases..................................................................................................................... X. Conclusion .................................................................................................................................... Appendix A: Members of the ABI Commission to Study the Reform of Chapter  ........ Appendix B: Research Assistants and Empiricists................................................................................. v Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 6 of 402 American Bankruptcy Institute Appendix C: Advisory Committee Members ............................................................................................... Appendix D: Public Field Hearing Witness List ...................................................................................... Appendix E: Summary of Field Hearings and Topics of Discussion ............................................ Appendix F: Academics Involved in April  Symposium .............................................................. Appendix G: Additional Views on Severance Benefits Principles .............................................. in cited vi 16 1, 20 ber 2 vem n No ed o rchiv 63 a -353 . 14 , No rown .B eth v Blixs Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 7 of 402 16 1, 20 ber 2 vem n No ed o rchiv 63 a -353 . 14 , No rown .B eth v Blixs I. INTRODUCTION in cited Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 8 of 402 American Bankruptcy Institute A robust, effective, and efficient bankruptcy system rebuilds companies, preserves jobs, and facilitates economic growth with dynamic financial markets and lower costs of capital. For more than 35 years, the U.S. Bankruptcy Code has served these purposes, and its innovative debtor in possession chapter 11 process, which allows a company to manage and direct its reorganization efforts, is emulated around the globe. As with any law or regulation, however, periodic review of U.S. bankruptcy laws is necessary to ensure their continued efficacy and relevance. Whether by design or chance, efforts to review and assess U.S. business reorganization laws are undertaken approximately every 40 years. Such efforts have led to federal legislation effecting meaningful revisions to business reorganization laws in 1898, 1938, and 1978. It may be that four decades is the maximum amount of time that any financially driven regulation can remain relevant. Markets and financial products, as well as industry itself, often evolve far more quickly than the regulations intended to govern them. It may be that significant economic crises tend to occur cyclically and encourage reevaluation of the federal bankruptcy laws. Regardless, the general consensus among restructuring professionals is that the time has come once again to evaluate U.S. business reorganization laws. Accordingly, the American Bankruptcy Institute (the “ABI”) established the Commission to Study the Reform of Chapter 11 (the “Commission”) for this precise purpose. The Commissioners are among the most prominent insolvency and restructuring practitioners in 16 the United States, who have represented debtors, creditors, and other stakeholders, such as private 1, 20 ber 2 equity investors, in the largest and most significant cases in U.S. history. em Commissioners included Nov The d on hive cBankruptcy Conference, the immediate the Chair and former Chair of the influential Nationalr 3a 3536 . 14past Chair and former President of thenprestigious American College of Bankruptcy, two past , No ow v. Br Chairs of the New York City Barth e Committee on Bankruptcy and Reorganization, the former Chief Blixs Restructuring Officer itof the United States Treasury, a past Chair of the Turnaround Management ed in c Association, three prominent turnaround consultants, a past member of the National Bankruptcy Review Commission, a former Chief Bankruptcy Judge of the Southern District of New York, the two principal draftsmen of the 1978 Bankruptcy Code, several past members of the Advisory Committee on Bankruptcy Rules of the Judicial Conference of the United States, the current President of INSOL International, the Director of the Executive Office for U.S. Trustees in the Department of Justice,1 five past Presidents of the American Bankruptcy Institute, and nine current and former global heads of the bankruptcy departments at major U.S. law firms. The Commissioners and their full professional biographies, as well as that of the Reporter, are attached collectively at Appendix A. In assembling those who would serve as Commissioners and as members of the topical advisory committees, special attention was paid to the fact that although large cases capture headlines, the overwhelming number of business bankruptcies are by small and medium-sized enterprises. Professionals with unique experiences in these kinds of cases lent their special expertise to the Commission process. As a result, the Report includes, among others, recommendations focused on small and medium-sized enterprises that will materially improve the Bankruptcy Code for stakeholders in this broad market. 1 As a nonvoting member, Director Cliff White took no position on legislative proposals. Mr. White provided institutional perspectives and technical assistance on issues considered by the Commission.  I. Introduction Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 9 of 402 ABI Commission to Study the Reform of Chapter  The Commission adopted a holistic and inclusive approach to its study and was guided by its mission statement, which reads: In light of the expansion of the use of secured credit, the growth of distressed-debt markets and other externalities that have affected the effectiveness of the current Bankruptcy Code, the Commission will study and propose reforms to Chapter 11 and related statutory provisions that will better balance the goals of effectuating the effective reorganization of business debtors — with the attendant preservation and expansion of jobs — and the maximization and realization of asset values for all creditors and stakeholders. In furtherance of its mission statement, the Commission undertook an in-depth three-year study process. The study focused exclusively on the resolution of financially distressed businesses under chapter  11 of the Bankruptcy Code.2 This Report explains the components of the Commission’s study process, summarizes the results of the study, and presents the Commission’s resulting recommendations for reform in a series of principles organized generally by issue and sequence in the chapter 11 process. Although the Commission designed its three-year process around concepts of inclusiveness, diversity of thought, leadership, and transparency, the Commission, working with the Commission’s Reporter, Professor Michelle M. Harner, University of Maryland Francis King Carey School of Law, maintained 2016 exclusive control over the substance of the final Report. All decisions ber 2recommendations set forth and 1, vem in the Report were made solely by the Commissioners ed on No in accordance with the voting procedures rchiv described herein. The Reporter worked closely 63 a the Commissioners to draft the language of -353 with . 14 the recommended principles andrown, supporting narrative for each of those principles. Although the No B h v. the Reporter acted as thesprincipal draftsperson of the Report, the Commissioners reviewed and x et n Bli i commented on cited various iterations of this Report to achieve this final product. The Commission voted unanimously to adopt this Report on December 1, 2014. During the three-year study and the drafting process, the Commission was assisted in its research by Leah Barteld Clague, Jennifer Ivey-Crickenberger, and Sabina Jacobs, as well as each of the Commission’s advisory committees and their respective reporters. The Commission appreciates the assistance of all of these individuals, and acknowledges the substantial value added to this Report by the work of the advisory committees and the international working group.3 2 3 The Commission did not address issues unique to the resolution of an individual debtor’s financial distress under chapter 11. For a general discussion of these issues, see Section IX.C, Individual Chapter 11 Cases. Additional information regarding the Commission’s research assistants and the empiricists who assisted with research underlying the report are identified at Appendix B. Members of the advisory committees are listed at Appendix C, and members of the international working group are listed below, infra note 53. In addition, this Report also benefited from datasets made available to the Commission by New Generations, UCLA-LoPucki Bankruptcy Research Databases, and the Loan Syndications and Trading Association. I. Introduction  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 10 of 402 Bankruptcy Institute in cited  I. Introduction 16 1, 20 ber 2 vem n No ed o rchiv 63 a -353 . 14 , No rown .B eth v Blixs Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 11 of 402 16 1, 20 ber 2 vem n No ed o rchiv 63 a -353 . 14 , No rown .B eth v Blixs II. EXECUTIVE SUMMARY OF PROPOSED PRINCIPLES in cited American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 12 of 402 Bankruptcy Institute Chapter 11 works to rehabilitate companies, preserve jobs, and provide value to creditors only if distressed companies and their stakeholders actually use the chapter 11 process to facilitate an incourt or out-of-court resolution of the company’s financial distress.4 Chapter 11 in turn needs to offer tools to resolve a debtor’s financial distress in a cost-effective and efficient manner. To that end, the recommended principles seek to, among other things: Reduce barriers to entry by providing debtors more flexibility in arranging debtor in possession financing, clarifying lenders’ rights in the chapter 11 case, disclosing additional information about the debtor to stakeholders, and providing a true breathing spell at the beginning of the case during which the debtor and its stakeholders can assess the situation and the restructuring alternatives; Facilitate more timely and efficient diligence, investigation, and resolution of disputed matters through an estate neutral — i.e., an individual that may be appointed depending on the particular needs of the debtor or its stakeholders to assist with certain aspects of the chapter 11 case, as specified in the appointment order; Enhance the debtor’s restructuring options by eliminating the need for an accepting impaired class of claims to cram down a chapter 11 plan and by formalizing a process to permit the sale of all or substantially all of the debtor’s assets outside the plan process, while strengthening the protection of creditors’ rights in such situations; 6 1 , 20 er 21 emb debtor and of creditors, Incorporate checks and balances on the rights and remediesvof the No d on chive enhance a debtor’s liquidity during including through valuation concepts that potentially ar 5363 the case, permit secured creditorsNo. realize the reorganization value of their collateral at to 14-3 wn, the end of the case, andth v. Bro value allocation to junior creditors when supported by the e provide ixs in Bl reorganizationdvalue; and cite Create an alternative restructuring scheme for small and medium-sized enterprises that would enable such enterprises to utilize chapter 11 and would enable the court to more efficiently oversee the enterprise through a bankruptcy process that incentivizes all parties, including enterprise founders and other equity security holders, to work collectively toward a successful restructuring. The Report organizes the recommended principles based on the key stages of a chapter  11 case: Commencing the Case; Administering the Case; and Exiting the Case. In addition, the Report proposes a set of principles for Small and Medium-Sized Enterprises. Finally, the Report includes a section on issues related to chapter 11 cases, but not directly tied to the Commission’s mission statement or addressed by this Report. This final section discusses, among other things, issues relating to venue and jurisdiction in chapter 11 cases. 4 The utility of the chapter 11 process is important not only for companies that file chapter 11 cases, but also for companies trying to achieve an out-of-court resolution. Distressed companies and their stakeholders frequently consider the federal bankruptcy alternative in deciding whether to pursue or ultimately agree to an out-of-court restructuring plan.  II. Executive Summary of Proposed Principles Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 13 of 402 16 1, 20 ber 2 vem n No ed o rchiv 63 a -353 . 14 , No rown .B eth v Blixs III. BACKGROUND ON THE COMMISSION AND THE STUDY PROJECT in cited American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 14 of 402 Bankruptcy Institute Congress historically has turned to U.S. bankruptcy laws to help stabilize the economy in times of crisis and, beginning in 1867, to provide both individuals and corporations a single forum to address multiple creditor claims.5 Although the law has evolved significantly since the late 1800s, the law remains focused on strengthening the economy and society more generally and, in the process, instilling confidence in businesses and markets. These objectives require a delicate balance that encourages appropriate growth and innovation in business, but provides sufficient protection and certainty to creditors.6 Chapter 11 of title 11 of the U.S. Code (the “Bankruptcy Code”) can achieve this balance for U.S. companies and markets. This section reviews the historical development of the Bankruptcy Code, explains why it is important and necessary to consider reforms to the Bankruptcy Code at this point in time, and details the Commission’s study process that generated this Report and Recommendations. A. Brief History of U.S. Business Reorganization Laws The United States has one of the strongest and most well developed business reorganization schemes in the world.7 This business reorganization scheme has a rich history, stemming in large part from the railroad failures of the late 19th century.8 The Bankruptcy Acts of 1867 and 1898 introduced the basic conceptual underpinnings of modern bankruptcy law, including business2bankruptcy.9 These 016 21, berand rehabilitate” policy laws, particularly the 1898 Bankruptcy Act, were grounded in a Novem “rescue n ed o the business debtor, to obtain a intended to allow the honest but unfortunate debtor, archiv including 63 -353 fresh start and a second chance at becoming. 14productive, contributing member of society.10 As a , No rown with all U.S. bankruptcy laws, the v. B Bankruptcy Act sought to balance the need of the debtor 1898 th e Blixs ed in cit 5 6 7 8 9 10  See, e.g., Charles Jordan Tabb, The History of the Bankruptcy Laws in the United States, 3 Am. Bankr. Inst. L. Rev. 5, 18–23 (1995). One commentator explained: The current U.S. bankruptcy system grew directly out of the United States’ unique capitalist system, which rewards entrepreneurialism as well as extensive consumer spending. It makes sense that a society in which dollars rule would have a forgiving personal bankruptcy system in order to keep consumer spending high, and an equally forgiving business reorganization system to encourage risk taking and economic growth. Both systems are part of a larger scheme to keep economic players alive and active in the game of capitalism. U.S. bankruptcy systems are among the country’s few social programs and they address many of society’s ills. Thus, they are broad and form an integral part of the social system from which they sprung. Nathalie Martin, The Role of History and Culture in Developing Bankruptcy and Insolvency Systems: The Perils of Legal Transplantation, 28 B.C. Int’l & Comp. L. Rev. 1, 3 (2005). See also Viral V. Acharya et al., Creditors Rights and Corporate RiskTaking, 102 J. Fin. Econ. 150, 150–66 (Oct. 2011) (“In cross-country analysis, we find that stronger creditor rights induce greater propensity of firms to engage in diversifying acquisitions that are value-reducing, to acquire targets whose assets have high recovery value in default, and to lower cash-flow risk. Also, corporate leverage declines when creditor rights are stronger.”). See, e.g., Martin, supra note 6, at 4 (“[M]any countries have attempted to create a reorganization scheme for failing enterprises like Chapter 11 of the U.S. Bankruptcy Code (Chapter 11), in which existing management stays in place and manages the reorganizing company. These systems are perhaps the most common U.S. legal exports today.”) (citations omitted). Harvey R. Miller & Shai Y. Waisman, Does Chapter 11 Reorganization Remain a Viable Option for Distress Businesses for the Twenty-First Century?, 78 Am. Bankr. L.J. 153, 160 (2004) (“The foundation of United States reorganization law is the equity receivership, also known as the federal consent receivership, that was fashioned in the late nineteenth century to resolve the financial distress and failures that permeated the railroad industry after the Civil War.”). For general discussions of the historical development of federal bankruptcy law, see, e.g., David A. Skeel, Jr., Debt’s Dominion 56–60 (2001) (explaining equity receivership process); Charles Jordan Tabb, The History of the Bankruptcy Laws in the United States, 3 Am. Bankr. Inst. L. Rev. 5, 21–23 (1995) (same). See also Charles Warren, Bankruptcy in United States History (1935); Donald R. Korobkin, Rehabilitating Values: A Jurisprudence of Bankruptcy, 91 Colum. L. Rev. 717, 747–49 (1991); Stephen J. Lubben, A New Understanding of the Bankruptcy Clause, 64 Case W. Res. L. Rev. 319 (2014). See Jason J. Kilborn, Bankruptcy Law, in Governing America: Major Decisions of Federal, State, and Local Governments from 1789 to the Present 41–49 (Paul J. Quirk & William Cunion eds., 2011) (“With the rise of private business corporations in the mid- to late-1800s, the rescue- and rehabilitation-oriented bankruptcy policy was extended to the ‘big business’ context.”). The 1898 Bankruptcy Act initially permitted “[c]ompositions in lieu of liquidations,” and then subsequent amendments, described below, enlarged rehabilitation alternatives for businesses. See Tabb, supra note 9, at 26–30. III. Background on the Commission and the Study Project Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 15 of Chapter  to rehabilitate and the rights of creditors to recoveries. The basic notion that a business generally is more valuable to creditors and society as a whole if it rehabilitates rather than liquidates also emerged during this period.11 Bankruptcy law progressed in response to, among other things, the Great Depression of the 1930s,12 and a more formalized process evolved that allowed distressed companies to remain in business while restructuring their obligations.13 These developments produced Sections 77 and 77B of the Bankruptcy Act14 and then the Bankruptcy Code’s immediate predecessor, the Chandler Act,15 which added three new chapters for reorganizing ongoing businesses (Chapters X and XI concentrated on businesses, and Chapter XII addressed real estate organizations).16 Each iteration of the law focused on strengthening business reorganizations and seeking an appropriate balance between the rights and obligations of the debtor and its stakeholders. Under Chapter X of the Chandler Act, a trustee was appointed to replace the debtor’s management, and the Securities and Exchange Commission had a formal oversight role in the reorganization process.17 The large public companies subject to Chapter X did not embrace these two requirements.18 They worked to avoid a bankruptcy filing — even when arguably necessary or prudent under the circumstances — or tried to come within the provisions of Chapter  XI of the Chandler Act.19 Chapter XI was intended for smaller, nonpublic companies and only addressed unsecured debt in the debtor’s capital structure. Nevertheless, companies generally preferred this chapter because it 16 1, 20 ber 2 ovem 11 See, e.g., Charles J. Tabb, The Future of Chapter 11, 44 S.C. L. Rev. 791, 803on N (“This idea that the preservation of a business ed (1993) employees, and the public generally — is as a going concern is better for everyone — creditors, stockholders, bondholders, rchiv 63 a not a new one. It has been around for at least a century, really ever since the Industrial Revolution reached full flower.”). James -353 4 Madison was a proponent of early recognition of o. 1 , N bankruptcy laws, “[t]he power of establishing uniform laws of bankruptcy is so r of n intimately connected with the regulationowcommerce, and will prevent so many frauds where the parties or their property may B h v. lie or be removed into different states, that the expediency of it seems not likely to be drawn into question.” Miller & Waisman, xset n Bli Remain a Viable Option for Distress Businesses for the Twenty-First Century?, supra note 8, at 159 i Does Chapter 11 Reorganization cited 12 13 14 15 16 17 18 19 & n. 4 (quoting The Federalist No. 42, at 271 (James Madison) (Clinton Rossiter ed., 1961)). See, e.g., Tabb, supra note 9, at 22. “One of the primary purposes of the Bankruptcy Act is to ‘relieve the honest debtor from the weight of oppressive indebtedness, and permit him to start afresh free from the obligations and responsibilities consequent upon business misfortunes.” Local Loan Co. v. Hunt, 292 U.S. 234, 244 (1934). See also David S. Kennedy & R. Spencer Clift III, An Historical Analysis of Insolvency Laws and Their Impact on the Role, Power, and Jurisdiction of Today’s United States Bankruptcy Court and Its Judicial Officers, 9 Norton J. Bankr. L. & Prac. 165, 176 (2000) (“The Chandler Act was the Congressional response to the depression and was modeled after the emergency legislation of the early 1930’s. Since 1938, there has existed in America a Congressional policy favoring reorganization over liquidation, where possible.”). Sections 77 and 77B of the 1898 Bankruptcy Act adopted various features of the equity receivership model of reorganization historically used for railroads and applied those features to railroads and other business entities. See, e.g., Skeel, supra note 9, at 54, 106; Bussel, infra note 17, at 1555–56. “[The Chandler Act] was far-reaching in its scope and purpose. The Act comprised 15 chapters; the first seven chapters dealt with the liquidation provisions substantially based upon the original 1898 Act while chapters eight through fifteen dealt primarily with the rehabilitation of various classes of debtors.” Kennedy & Clift, supra note 13, at 176. For a detailed history and analysis of the Chandler Act, see Vincent L. Leibell, Jr., The Chandler Act — Its Effect Upon the Law of Bankruptcy, 9 Fordham L. Rev. 380, 385–409 (1940). See, e.g., Alexander L. Paskay & Frances Pilaro Wolstenholme, Chapter 11: A Growing Cash Cow Some Thoughts on How to Rein in the System, 1 Am. Bankr. Inst. L. Rev. 331, 331 nn. 3 & 4 (briefly explaining Chapters X, XI, and XII). See, e.g., SEC v. Am. Trailer Rentals Co., 379 U.S. 594, 603–06 (1965) (explaining development of the Chandler Act); Daniel J. Bussel, Coalition-Building Through Bankruptcy Creditors’ Committees, 43 UCLA L. Rev. 1547, 1557–58 (1996) (explaining key elements of Chapter X). See Skeel, supra note 9, at 123–27 (explaining the general negative corporate reaction to Chapter X and noting that “[t]he independent trustee requirement discouraged the managers of large firms from filing for bankruptcy if there was any way to avoid it”). See id. at 125–27. See also A. Mechele Dickerson, Privatizing Ethics in Corporate Reorganizations, 93 Minn. L. Rev. 875, 890 (2009) (“The harsh treatment managers received in Chapter X discouraged managers from using that Chapter and ultimately caused Chapter XI to become the dominant reorganization vehicle for even large, publicly traded companies that ostensibly should have filed under the trustee-controlled Chapter X.”). See Harvey R. Miller, Bankruptcy and Reorganization Through the Looking Glass of 50 Years (1960–2010), 19 Norton J. Bankr. L. & Prac. 3 Art. 1 (1993) for a brief comparison about the treatment of debtors and their management under Chapter X versus Chapter XI). For example, one source suggests that only a minor portion of business bankruptcies were in fact commenced through Chapter X (e.g., 0.6 percent of total filings in 1971). David T. Stanley & Marjorie Girth, The Brookings Inst., Bankruptcy: Problems, Process, and Reform (1971). III. Background on the Commission and the Study Project  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 16 of 402 Bankruptcy Institute placed the reorganization largely in the hands of the debtor and its unsecured creditors’ committee and was premised on the efforts of these parties to structure a negotiated resolution to the debtor’s financial distress.20 After almost 40 years of restructuring experience under Chapter X and Chapter XI of the Chandler Act, policymakers and practitioners agreed that reform was needed.21 Consequently, in 1970, Congress created the Commission on the Bankruptcy Laws of the United States (the “Commission on Bankruptcy Laws”) to “study, analyze, evaluate and recommend changes to the [1898] Act.”22 In 1973, the Commission on Bankruptcy Laws issued a report and a draft of proposed bankruptcy legislation.23 The National Conference of Bankruptcy Judges, excluded from the Commission on Bankruptcy Laws, submitted a competing legislative proposal.24 President Carter ultimately signed into law the 1978 Bankruptcy Code, which combined various concepts from both legislative proposals and merged Chapters X, XI, and XII of the 1898 Bankruptcy Act into a single business reorganization chapter (the current chapter 11).25 In passing the Bankruptcy Code, Congress believed that “the purpose of a business reorganization case [under chapter 11] . . . is to restructure a business’s finances so that it may continue to operate, provide its employees with jobs, pay its creditors, and produce a return for its stockholders”26 with the understanding that “reorganization, in its fundamental aspects, involves the thankless task of determining who should share the losses incurred by an unsuccessful business and how the values of the estate should be apportioned among creditors and stockholders.”27 6 1 After its enactment, Congress amended the Bankruptcy Code on a eperiodic and piecemeal 1, 20 b r2 ve basis. In 1982, Congress broadened protections for the commodities m securities markets.28 In n No and ed o rch 1984, Congress clarified the jurisdiction of the bankruptcyivcourts, set the term and appointment 63 a -353 .1 procedures of bankruptcy judges, and enacted4 specialized rules for the treatment of collective , No rown bargaining agreements.29 In 1986,h v. B et Congress created additional bankruptcy judgeships, expanded the Blixs U.S. Trustee pilot program to a nationwide program,30 and codified chapter 12 for family farmers.31 ed in cit In 1988, Congress added protections for retirees and intellectual property licensees, and resolved conflicts between bankruptcy law and state laws.32 In 1990, Congress added various provisions, such as swap protections, making certain debts nondischargeable, and establishing bankruptcy appellate panels.33 In 1992, Congress added more provisions related to, among others, judgeships and chapter 20 21 22 23 24 25 26 27 28 29 30 31 32 33  See Bussel, supra note 17, at 1557–58 (explaining key elements of Chapter XI). Elizabeth Warren, Bankruptcy Policymaking in an Imperfect World, 92 Mich. L. Rev. 336, 371–73 (1993) (“One of the key reasons for the adoption of the 1978 Code was the widespread perception that the old Code was unworkable.”). Act of July 24, 1970 Establishing a Commission on the Bankruptcy Laws of the United States, Pub. L. No. 91-354, 84 Stat. 468 (1970). For further discussion about the Commission on Bankruptcy Laws and its composition, see Report of the Commission on the Bankruptcy Laws of the United States, 29 Bus. Law. 75, 75–76 (1973). Report of the Commission on the Bankruptcy Laws of the United States, H.R. Doc. No. 93-137 (1st Sess. 1973). See also Report, supra note 22; Frank R. Kennedy, The Report of the Bankruptcy Commission: The First Five Chapters of the Proposed New Bankruptcy Act, 49 Ind. L.J. 422 (1974). See Kenneth N. Klee, Legislative History of the New Bankruptcy Law, 28 DePaul L. Rev. 941, 943–44 (1979). See Tabb, supra note 9, at 35. Harvey R. Miller & Shai Y. Waisman, Is Chapter 11 Bankrupt?, 47 B.C. L. Rev. 129, 181 (2005) (quoting H.R. Rep. No. 95-595, at 220 (1978), reprinted in 1978 U.S.C.C.A.N. 5963, 6179). Id. (quoting S. Rep. No. 95-989, at 10 (1978), reprinted in U.S.C.C.A.N. 5787, 5796). See 1 Norton Bankr. L. & Prac. 3d § 2:11. See id. § 2:12. The U.S. Trustee Program was piloted in certain judicial districts prior to the 1986 legislation. The 1986 legislation made the program permanent nationwide, with the exception of North Carolina and Alabama. Bankruptcy cases in Alabama and North Carolina are not under the jurisdiction of the U.S. Trustee, but rather are administrated by Bankruptcy Administrators in those jurisdictions. See 1 Norton Bankr. L. & Prac. 3d § 2:13. See id. § 2:14. See id. § 2:15. III. Background on the Commission and the Study Project Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 17 of Chapter  12.34 In 1994, Congress again added various provisions, including changes in time limits, exemptions, and criminal penalties.35 In 1994, Congress also created the National Bankruptcy Review Commission (the “NBRC”) to foster a more systemic look at studying and reforming the Bankruptcy Code.36 The NBRC issued its report in 1997,37 and several of its recommendations were addressed to varying degrees in the amendments to the Bankruptcy Code set forth in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the “BAPCPA Amendments”).38 BAPCPA implemented an extensive overhaul of both the business and consumer provisions of the Bankruptcy Code.39 BAPCPA and the prior amendments affecting chapter 11 tried to address perceived deficiencies in the Bankruptcy Code, but have in some respects altered the Bankruptcy Code’s original careful balance between a debtor’s need to rehabilitate and its creditors’ rights to recoveries on their claims against the debtor. In addition, the amendments have introduced perceived inequities among different creditor constituencies. These factors, combined with the changing economic environment and other externalities discussed below, have diluted the effectiveness of chapter 11 for many companies and their stakeholders. Reminiscent of the time preceding the work of the Commission on Bankruptcy Laws, companies once again are working to find alternatives to filing bankruptcy cases, potentially at the expense of their creditors, shareholders, and employees.40 Accordingly, after more than 35 years of experience under chapter 11, many practitioners and commentators agree 6 , 201 that it is again time for reform.41 er 21 34 35 36 37 38 39 40 41 in ited b ovem on N ived arch 363 -35 o. 14 n, N Brow th v. lixse B See id. § 2:16. c See id. § 2:17. National Bankruptcy Review Comm’n Act, Pub. L. No. 103-394 §§ 601–702, 108 Stat. 4147 (codified at 11 U.S.C. § 101 (1994)). For more information about the NBRC and its composition, see http://govinfo.library.unt.edu/nbrc/index.html. National Bankruptcy Review Commission Final Report: Bankruptcy: The Next Twenty Years, Oct. 20, 1997, available at http:// govinfo.library.unt.edu/nbrc/reporttitlepg.html [hereinafter NBRC Report]. See Susan Jensen, A Legislative History of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, 79 Am. Bankr. L.J. 485, 487–88 (2005). Lubben, supra note 9, at 407–08. A restructuring law that companies seek to avoid at all costs can exasperate companies’ financial distress and negatively impact the overall economy. It can cause companies to increase leverage beyond sustainable levels in the hopes of buying time to find outof-court solutions. It can encourage companies to engage in speculative projects, undertake precipitous reductions in workforce, and delay payments to vendors and suppliers who in turn may experience financial difficulties. This was the state of U.S. business bankruptcy laws in 1978 when Congress enacted the Bankruptcy Code to overhaul Chapters X and XI of the 1898 Bankruptcy Act. It is again the state of U.S. business bankruptcy laws, with companies — particularly small and medium-sized enterprises — avoiding a chapter 11 filing whenever possible because of inefficiencies, uncertainty, and costs associated with the chapter 11 process. See, e.g., infra note 60; Exploring Chapter 11 Reform: Corporate And Financial Institution Insolvencies; Treatment of Derivatives: Hearing Before the Subcomm. on Regulatory Reform, Commercial and Antitrust Law of the H. Comm. on the Judiciary, 113th Cong. (Mar. 26, 2014) (written testimony of Professor Michelle M. Harner, Co-Director, Business Law Program, University of Maryland Francis King Carey School of Law), at 2 & nn. 7–9 (noting that chapter 11 has become too expensive for businesses and causes companies to close rather than timely file for bankruptcy, which has adverse consequences for the companies, their employees, and the economy) (citations omitted), available at http://judiciary.house.gov/index.cfm/2014/3/hearing-exploring-chapter-11-reform-corporate-andfinancial-institution-insolvencies-treatment-of-derivatives. See Richard Levin & Kenneth Klee, Rethinking Chapter 11, Int’l Insolvency Inst., Twelfth Annual Int’l Insolvency Conf. (June 21–22, 2012), available at http://www.iiiglobal.org/component/jdownloads/finish/337/5966.html. See also Douglas G. Baird & Robert K. Rasmussen, Chapter 11 at Twilight, 56 Stan. L. Rev. 673 (2003); Stephen J. Lubben, Some Realism About Reorganization: Explaining the Failure of Chapter 11 Theory, 106 Dick. L. Rev. 267 (2001); Harvey R. Miller, Chapter 11 in Transition — From Boom to Bust and into the Future, 81 Am. Bankr. L.J. 375 (2007); Miller & Waisman, Does Chapter 11 Reorganization Remain a Viable Option for Distressed Businesses for the Twenty-First Century?, supra note 8; Miller & Waisman, Is Chapter 11 Bankrupt?, supra note 26; James H. M. Sprayregen et al., Chapter 11: Not Perfect, but Better than the Alternative, Am. Bankr. Inst. J., Oct. 2005, at 1; Written Statement of Bettina M. Whyte: ASM Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (Apr. 19, 2012) (providing an intriguing narrative story of how times have changed and the Bankruptcy Code has not), available at Commission website, infra note 55. III. Background on the Commission and the Study Project  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 18 of 402 Bankruptcy Institute B. The Need for Reform Chapter 11 of the Bankruptcy Code has served us well for many years. Nevertheless, today’s financial markets, credit and derivative products, and corporate structures are very different than those existing in 1978 when Congress enacted the Bankruptcy Code. Companies’ capital structures are more complex and rely more heavily on leverage, which is secured under state enactments of the Uniform Commercial Code that encumber vastly more assets than in 1978;42 their asset values are driven less by hard assets (e.g., real estate and machinery) and more by services, contracts, intellectual property, and other intangible assets; and both their internal business structures (e.g., their affiliates and partners) and external business models are increasingly multinational. In addition, claims trading and derivative products have changed the composition of creditor classes. Although these developments are not unwelcome or unhealthy, the Bankruptcy Code was not originally designed to rehabilitate companies efficaciously in this complex environment.43 Moreover, anecdotal evidence suggests that chapter 11 has become too expensive (particularly for small and medium-sized enterprises) and is no longer capable of achieving certain policy objectives such as stimulating economic growth, preserving jobs and tax bases at both the state and federal level, or helping to rehabilitate viable companies that cannot afford a chapter 11 reorganization.44 Some professionals suggest that more companies are liquidating or simply closing their doors without trying to rehabilitate under the federal bankruptcy laws.45 Commentators16 professionals , 20 and er 21 emb also suggest that companies are waiting too long to invoke the federal v No bankruptcy laws, which limits d on 46 chive companies’ restructuring alternatives and may lead to 3 ar 6 premature sales or liquidations. 42 43 44 45 46  53 14-3 No. wn, . Bro eth v Blixs See, e.g., Mark Jenkins &ted in C. Smith, Creditor Conflict and the Efficiency of Corporate Reorganization, (paper presented at David ci April 2014 symposium) (draft on file with Commission) (“Secured debt represented less than 45 percent of the debt of Moody’srated firms filing for bankruptcy in 1991; by 2012, secured debt accounted for more than 70 percent of the debt of Moody’srated bankruptcy filers.”), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2444700. For a discussion of the amendments to the Uniform Commercial Code and their potential impact on secured creditors’ collateral packages, see Section VI.C.4, Section 552(b) and Equities of the Case. See, e.g., Ralph Brubaker, The Post-RadLAX Ghosts of Pacific Lumber and Philly News (Part II): Limiting Credit Bidding, Bankr. L. Letter, July 2014, at 4 (“Two monumental developments in Chapter 11 practice that the Code drafters likely did not anticipate, though, have skewed negotiations over allocation of reorganization surplus decisively in favor of senior secured creditors, in a manner that the Code drafters also likely did not anticipate. The first is the ascendancy of secured credit in Chapter 11 debtors’ capital structures, such that it is now common that a dominant secured lender has blanket liens on substantially all of the debtor’s assets securing debts vastly exceeding the value of the debtor’s business and assets. The second, related phenomenon is the rise of ‘relatively expeditious going-concern sales of the debtor’s business and assets to a third-party purchaser’ as a prominent means of realizing the debtor’s going-concern value in Chapter 11.”) (citations omitted). See, e.g., Oral Testimony of Joseph McNamara: NACM Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (May 21, 2013) (“In my experience, over the last half decade, companies have had a harder and harder time successfully reorganizing their debt and using the chapter 11 process, and thus are more prone to either fold their reorganization procedure into a liquidation or successfully exit and then re-enter bankruptcy a few short years later.”), available at Commission website, infra note 55. See also Stephen J. Lubben, What We “Know” About Chapter 11 Cost is Wrong, 17 Fordham J. Corp. & Fin. L. 1 (2012) (reviewing literature and presenting empirical data to contradict common perceptions of bankruptcy costs); Written Statement of John Haggerty, Argus Management Corp.: ASM Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (Apr. 19, 2013) (describing an increase in the use of nonbankruptcy alternatives, including increased unsupervised winddowns, as a result of the costs and loss of control associated with chapter 11), available at Commission website, infra note 55; Oral Testimony of John Haggerty, Argus Management Corp.: ASM Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 36 (Apr. 19, 2013) (ASM Transcript) (describing how the DIP budget for professionals’ fees has ballooned and noting that such costs keep small businesses out of chapter 11), available at Commission website, infra note 55. See, e.g., Douglas G. Baird & Robert K. Rasmussen, The End of Bankruptcy, 55 Stan. L. Rev. 751, 777–85 (2002) (discussing decrease in traditional stand-alone reorganizations). See also Oral Testimony of Dan Dooley: ASM Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 37 (Apr. 19, 2013) (ASM Transcript) (describing increased use of state and local receiverships and ABCs in lieu of chapter 11 or chapter 7 because of the reduced costs and reduced delay), available at Commission website, infra note 55. See, e.g., Michelle M. Harner & Jamie Marincic Griffin, Facilitating Successful Failures, 66  Fla. L. Rev. 205 (2014) (analyzing literature and presenting results of empirical survey on, among other things, timing of bankruptcy filings). See generally infra note 66 and accompanying text (generally discussing limitations of chapter 11 empirical studies). III. Background on the Commission and the Study Project Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 19 of Chapter  Not all commentators agree that significant reform to chapter 11 is necessary. Some suggest that any changes could have unintended consequences or negatively impact credit markets. Others simply suggest that the system continues to work well enough.47 These issues are at the heart of the Commission’s study. As explained below, the Commission’s process was designed to explore the new environment in which financially distressed companies operate and to determine what aspects of the current system are — and are not — working as well as possible. C. The Commission’s Study The Commission has undertaken a methodical study of chapter 11 of the Bankruptcy Code. Over 250 corporate insolvency professionals (including the Commissioners, committee members, and hearing witnesses) participated in this study. The Commission has strived to include all perspectives, ideologies, and geographic and industry segments. Notably, the Commission’s process resembles that of the 1970 Commission on Bankruptcy Laws and, more recently, the 1994 NBRC in several respects. For example, the Commission used an advisory committee structure, described below, similar to the eight-topic committee2016 structure invoked by the 21, 48 ber for addressing and deciding NBRC. Similar to the NBRC, the Commissioners retained authority m Nove e by each issue.49 Moreover, each of the field hearings hosted d onthe Commission and described below hiv 3 arc 3536 was open to the public, and the transcripts -(and, in many cases, video recordings) are posted on 14 No. the Commission’s website at v. Brown, www.commission.abi.org (the “Commission website”). In addition, eth similar to the process followed by the NBRC, the Commissioners appeared at restructuring events Blixs ed in cit throughout the country to discuss and publicize the Commission’s work and to solicit feedback from affected constituents.50 The Commission has met on a regular basis since January 2012. During these meetings, the Commission has, among other things, discussed issues perceived as potential problems in chapter 11, reviewed recent developments in the case law and practice norms, and developed an effective process for identifying, researching, and analyzing chapter 11 as a whole. As explained below, the Commission used its advisory committees and numerous public field hearings to amass the information and research it required to critically analyze chapter 11 and consider any reform measures. The Advisory Committees. To launch its study, the Commission identified 13 broad study topics to facilitate a detailed analysis of the various components of chapter 11. These study topics are: (1) administrative claims and other pressures on liquidity; (2) avoiding powers (e.g., preferences and fraudulent conveyances); (3) bankruptcy-remote and bankruptcy-proof entities; (4) distributional issues under plans; (5) executory contracts and unexpired leases; (6) financial contracts, derivatives, 47 48 49 50 See, e.g., Stuart C. Gilson, Coming Through a Crisis: How Chapter 11 and the Debt Restructuring Industry Are Helping to Revive the U.S. Economy, 24 J. Applied Corp. Fin. 23 (2012). See NBRC Report, supra note 37, at 60–61. See id. at 61. See id. at 63. III. Background on the Commission and the Study Project  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 20 of 402 Bankruptcy Institute and safe harbors; (7) financing issues; (8) governance and supervision of cases; (9) labor and benefits issues; (10) multiple entities and corporate groups; (11) procedural and structural issues under plans; (12) role of valuation; and (13) asset sales in chapter 11.51 The Commission then enlisted the volunteer service of more than 150 of the insolvency profession’s expert judges, lawyers, financial advisors, academics, and consultants to serve on advisory committees for each of these study topics.52 In forming the advisory committees, the Commission carefully vetted individuals who were qualified to address particular issues within any given advisory committee’s charge. This vetting process considered not only the individual’s knowledge and expertise in the area, but also whether the individual would be likely to add a particular perspective on the issues while still considering the overall integrity of the bankruptcy system. As such, each advisory committee received input from the perspective of the various chapter 11 constituents — e.g., lenders, trade creditors, landlords, employees, etc. — on each of the issues they addressed and presented to the Commission. The diverse perspectives of the Commissioners and of the advisory committees added substantial value to the Commission’s deliberations and decisions and the proposals encompassed in this Report. The advisory committees began their work in April 2012. The Commission provided each advisory committee with a preliminary assessment containing initial study questions for its general topic area. Each advisory committee devoted significant time to researching and evaluating the study questions. The advisory committees met either in-person or telephonically on a frequent basis to review their 6 research and debate the issues. The advisory committees engaged in this work ,for1 1 20 approximately 18 ber 2 months before submitting research reports on most topics to the n Novem o Commission in December 2013. ived arch 363 5 The Commission then held a three-day ,retreat-3in February 2014 to meet with each advisory o. 14 n N Brow committee and discuss the research .reports. At the retreat, the advisory committees presented their th v lixse in B reports and highlighteddcomplex and nuanced issues for the Commission, and the Commissioners cite actively engaged in a direct dialogue with advisory committee members. The Commission also used the forum to begin integrating the study topics and reconciling overlapping issues. The retreat and the work of the advisory committees leading up to the retreat sessions were informative and very helpful to the Commission in this process. Since then, the Commission has reviewed the entire body of work produced by the advisory committees and conducted follow-up research and analysis on a variety of issues. The Commission also formed an international working group consisting of leading practitioners and academics from 13 different countries.53 The working group has studied targeted questions posed 51 52 53  The Commission deferred the work of the advisory committee on multiple entities and corporate groups; in the end, many of the study questions initially assigned to that committee overlapped with and were addressed by other committees or the Commission as a whole. As noted above, supra note 3, the names and affiliations of members of the advisory committees are listed at Appendix C. In addition, several of the advisory committees identified, and the Commission appointed, research fellows to provide research and other support for the work of those advisory committees. The Commission is grateful for the service and contributions of the advisory committee research fellows. Members of the international working group are: Dr. A. Klauser and L. Weber, from Austria; S. Atkins and Professor R. Mason, from Australia; Professor M. Vanmeenen and N. Wouters, from Belgium; S. Golick, from Canada; J-L. Vallens, M. André and R. Dammann, from France; Professor R. Bork, Professor S. Madaus and A. Tashiro, from Germany; Professor S. Bariatti and G. Corno, from Italy; H. Sakai, from Japan; Professor P.M. Veder and R.J. van Galen, from the Netherlands; Professor Wang Weigo and Professor Li Shuguang, from the People’s Republic of China; Professor F. Garcimartín and A. Núñez-Lagos, from Spain; Professor A. Boraine and A. Harris, from South Africa; Professor I.F. Fletcher, I. Williams, S. Bewick and R. Heis, from England and Wales; and G. Stewart and M. Robinson from INSOL International, and Professor B. Wessels and R.J. de Weijs, from the Netherlands as organizing members. Further contributions were made by E. Dellit, L. Farley, T. Hamilton, L. McCarthy and D. III. Background on the Commission and the Study Project Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 21 of Chapter  by the Commission and the advisory committees to provide a comparative analysis of the relevant issues. These questions generally involved the following broader topics: (i) the use of surcharges in sales; (ii) the treatment of intellectual property licenses in insolvency; (iii) financing options for insolvent companies; (iv) the role of administrators and monitors; (v) plan issues (presenting, voting, plans variations, and allocation rules); (vi) creditors’ or stakeholders’ committees; and (vii) claims trading.  The Field Hearings. The Commission held its first public hearing in April 2012 at the U.S. House of Representatives Committee on the Judiciary in the Rayburn House Office Building in Washington, D.C. Since that time, the Commission has held 16 public field hearings in 11 different cities: Boston, Las Vegas, Chicago, New York, Phoenix, San Diego, Tucson, Philadelphia, Austin, Atlanta, and Washington, D.C. Collectively, almost 90 individuals testified at these hearings.54 The testimony at each of these hearings was substantively rich and diverse. The hearings covered a variety of topics, including chapter  11 financing, general administrative and plan issues, governance, labor and benefits issues, priorities, sales, safe harbors, small and medium-sized enterprise cases, valuation, professionals’ fees, executory contracts (including commercial leases and intellectual property licenses), trade creditor issues, and reform of avoiding powers. Transcripts and videos of the hearings, and the related witness statements, are available at the Commission website.55 A summary of the hearing topics is attached at Appendix E. 6 1 Several common themes emerged from the field hearings. First, many rwitnesses acknowledged that 1, 20 be 2 include: chapter 11 cases have changed over time.56 These changes on Novem (1) a perceived increase in the d chive number and speed of asset sales under section 363 3 athe Bankruptcy Code;57 (2) a perceived decrease of r 3536 . 14- decrease in recoveries to unsecured creditors;58 and in stand-alone reorganizations; (3) anperceived , No ow v. Br associated with chapter 11.59 Second, the witnesses who testified (4) a perceived increase insthe costs eth Blix on issues relatingitto small and medium-sized enterprises generally opined that chapter 11 no longer ed in c 54 55 56 57 58 59 Elliott (Australia), C. Fell, M. Rochkin, S. Obal and Professor J. Sarra (Canada), L. Valentovish (Japan), L. Harms (South Africa) and C. E. Poolis (England). The names and affiliations of these witnesses are listed at Appendix D. All testimony and statements related to the Commission’s study from 2012 through 2014 that are cited in the Report are available at the Commission website at www.commission.abi.org [hereinafter Commission website]. See Oral Testimony of Bryan Marsal: NCBJ Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 15–19 (Oct. 26, 2012) (NCBJ Transcript) (“There is a gradual erosion of the underlying public principle of the Code which was to preserve jobs and maximize value through rehabilitation.”), available at Commission website, supra note 55; First Report of the Commercial Fin. Ass’n to the ABI Comm’n to Study the Reform of Chapter 11: Field Hearing at Commercial Fin. Ass’n Annual Meeting, at 2 (Nov. 15, 2012) (“[A] principal criterion for evaluating any proposed amendments to the Code is the extent to which they maximize the value of companies as going concerns (thereby preserving jobs and maximizing value for creditors), either through a reorganization in those situations where reorganization is a realistic option, or through a sale or liquidation where reorganization is not a realistic option.”), available at Commission website, supra note 55. See Oral Testimony of Gerald Buccino: TMA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 19 (Nov. 3, 2012) (TMA Transcript) (“When sales occur too quickly before the rehabilitative process, the yield to prepetition creditors is diminished.”), available at Commission website, supra note 55; Oral Testimony of Michael Richman: NCBJ Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 20 (Oct. 26, 2012) (NCBJ Transcript) (recommending that section 363 sales should be modified so that courts can restrain hasty sales and better monitor expedited sales), available at Commission website, supra note 55. See Written Statement of Paul Calahan: NACM Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (May 21, 2013) (“The Code and the economic environment have made it more difficult for unsecured creditors to realize fair payment of their claims . . . A voice for unsecured creditors is clearly needed and provides valuable insight to the court and other parties.”), available at Commission website, supra note 55; Written Statement of Joseph McNamara: NACM Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (May 21, 2013) (“A tremendous disparity remains between payment of secured and unsecured claims and some evidence suggests secured creditors with first liens experienced outstanding recoveries, while unsecured recoveries were around 20%, with the median recovery set at 10%.”), available at Commission website, supra note 55. See Written Statement of John Haggerty, Argus Management Corp.: ASM Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (Apr. 19, 2013) (recommending that the level of professionals should be rationalized at the onset of a case and fees and billing should be more transparent and have greater oversight during the process to keep overall costs down), available at Commission website, supra note 55. III. Background on the Commission and the Study Project  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 22 of 402 Bankruptcy Institute works for these companies. Witnesses cited cost and procedural obstacles as common barriers.60 Third, the witnesses who testified on financial contracts and derivatives generally agreed that the safe harbor protections have been extended to contracts and situations beyond the original intent of the legislation.61 They did not necessarily agree, however, on appropriate limitations or revisions to the relevant sections of the Bankruptcy Code.62 Finally, witnesses — even those who were highly critical of certain aspects of chapter 11 — all perceived value in the U.S. approach to corporate bankruptcies, including the debtor in possession model.63 In addition, the Commission worked with the University of Illinois College of Law to organize and host an academic symposium on the role of secured credit in business bankruptcies in April 2014. Nineteen of the nation’s leading bankruptcy scholars contributed to the symposium.64 The symposium was open to the public, and both the scholarship presented and a video recording of the event are posted on the Commission website. Many of the scholarly papers from this symposium will also be published in a forthcoming issue in the 2015 volume of the Illinois Law Review. D. The Commission’s Deliberations Immediately following its February 2014 retreat, the Commission began its in-depth review of the 16 1, 20 ber 2 advisory committees’ reports and recommendations, various issue-specific white papers prepared vem n No ed o by the Commission’s Reporter with the assistance of therchiv Commissioners and research fellows, the a 363 -35and papers submitted by hearing witnesses and papers from the Illinois symposium, and testimony . 14 , No rown restructuring professionals.65 ThehCommission then held five separate executive session retreats to .B et v Blixs deliberate, formulate, tandn vote on the content of this Report. Two of these retreats were held in ed i ci 60 61 62 63 64 65  See Written Statement of the Honorable Dennis Dow: Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (Apr. 19, 2013) (noting that the complexity, time, and costs of the chapter 11 process impose obstacles that small business debtors often cannot overcome), available at Commission website, supra note 55; Written Statement of Professor Anne Lawton: NCBJ13 Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (Nov. 1, 2013) (“The Code’s small business debtor definition should be simplified.”), available at Commission website, supra note 55; Oral Testimony of Gerald Buccino: TMA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 7, 15 (Nov. 3, 2012) (TMA Transcript) (“A one-size-fits-all approach for the Code does not work because smaller businesses have special needs.”), available at Commission website, supra note 55; Oral Testimony of Jeff Wurst: NYIC Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 28 (June 4, 2013) (NYIC Transcript) (stating smaller companies can no longer afford to seek protection under chapter 11), available at Commission website, supra note 55. See Written Statement of Daniel Kamensky on behalf of Managed Funds Association: LSTA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (Oct. 17, 2012) (asserting that the breadth of safe harbors has had unintended consequences and some courts have held that safe harbors extend to protect one-off private transactions that do not affect financial institutions), available at Commission website, supra note 55; Oral Testimony of Jane Vris on behalf of the National Bankruptcy Conference: NYCBC Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 9 (May 15, 2013) (NYCBC Transcript) (“The original purpose of the safe harbors was to preserve the clearing of payments and delivery within a fair closed system, the protections have now expanded beyond that.”), available at Commission website, supra note 55; Written Statement of Jane Vris on behalf of the National Bankruptcy Conference: NYCBC Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (May 15, 2013), available at Commission website, supra note 55. See Oral Testimony of the Honorable James Peck: NYCBC Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 31–32 (May 15, 2013) (NYCBC Transcript) (recommending that judges should have more discretion to determine whether contracts fit the criteria for protection under the safe harbors), available at Commission website, supra note 55. See Written Statement of William Greendyke: UT Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (Nov. 22, 2013) (reporting that the membership of the Bankruptcy Law Section of the State Bar of Texas noted that the chapter 11 process still worked, but found it to be more expensive and “faster” than 10 years ago), available at Commission website, supra note 55. The names and affiliations of the academics who presented at this symposium are listed at Appendix F. Certain of the materials that the Commission reviewed and discussed during the three-year study and deliberative process are identified in the footnotes in this Report. These citations capture but a fraction of the materials collected and reviewed by the Commissioners during this process. It simply was not feasible to cite all relevant sources and materials. The absence of a citation to a particular court opinion, empirical study, law review article, or witness’s testimony does not mean that such material was not considered and analyzed by the Commissioners. III. Background on the Commission and the Study Project Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 23 of Chapter  Virginia, two in New York, and one in Chicago. The Commission also held numerous subcommittee meetings in between each of these executive session retreats. At each of the executive sessions, the Commission reviewed issues raised by witness testimony or examined in the research materials prepared by the Reporter and the advisory committees, including the advisory committee’s recommendations on the initial study topics posed by the Commission. Moreover, the reports of the international working group informed many of the Commission’s deliberations. From these discussions, the Commissioners worked to identify areas of potential reform that would, among other things, improve case efficiencies, enhance business rehabilitations and creditors’ recoveries, and resolve uncertainty or ambiguity in the current law. During the three-year study process, and in connection with its deliberations, the Commission compiled and reviewed, among other materials, an extensive database of empirically based articles and working papers concerning different aspects of chapter 11 of the Bankruptcy Code. In reviewing all empirical data, including the data cited in this Report, the Commissioners were aware of the limitations that frequently impact chapter 11 data, including the following. First, endogeneity bias often is a problem in chapter 11 studies: (i) to the extent that omitted or unattainable information affects results (e.g., off-docket activity and negotiations; makeup of creditor body; talent or dynamics of management team; financial condition of debtor prior to and on petition date; impact of prepetition management decisions on company’s case; and, in some instances, economic or industry cycles), 6 omitted variable bias occurs; and (ii) when the causal direction between 201 variables cannot be 1, two ber 2 ve determined, simultaneity bias might occur (e.g., does the presence m private funds in a case make it n No of ed o more successful or do private funds invest in cases3 archiv better positioned to be more successful).66 that are 3536 . 14- of available data sources are not randomly sampled Second, selection bias can occur whenNo , subsets own v. Br or the pool from which xsethsample is drawn is not representative of the entire population (selfthe Bli d in selection bias cantealso limit empirical survey studies). Third, coder bias and intercoder reliability ci can skew interpretation or results (e.g., if more than one coder is involved in the project, each may interpret the often subjective items on a chapter 11 docket in different ways, despite efforts to achieve an acceptable intercoder reliability rate). Fourth, data are limited and subjective: for example, it is difficult to define “success” in chapter 11; it is difficult to determine if a plan is a traditional standalone reorganization or a merger or a third party sale — they are all change of control events, and many datasets do not capture these nuances; and outside of public bondholders, it is difficult to determine recoveries in chapter 11 cases, particularly for smaller cases. Finally, because of the biases and limitations noted above, as well as others not discussed here, it might be difficult to establish strong claims of causality in empirical studies of chapter 11 cases. Nevertheless, the Commission reviewed empirical data from numerous sources and supporting a variety of different positions on the issues before it; it found all of the data informative, and it used the data in its overall consideration of all relevant factors. The recommended principles set forth in this Report are the result of the Commission’s study and deliberative process. The Commissioners voted on each principle, and a principle was adopted as a Commission recommendation if it received support from two-thirds of the Commissioners voting, with 11 favorable votes being the minimum required for a principle being reported as a 66 See generally Michael R. Roberts & Toni M. Whited, Endogeneity in Empirical Corporate Finance, in Handbook of the Economics of Finance (2014) (discussing these issues with endogeniety, as well as measurement errors in that context). III. Background on the Commission and the Study Project  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 24 of 402 Bankruptcy Institute recommendation. If the requisite level of support was not obtained, this Report includes a description of the issue, a summary of the factors considered by the Commission in connection with the issue, and a notation that no consensus emerged. The Commission believed that this Report achieves its core mission to “study and propose reforms to Chapter 11 and related statutory provisions that will better balance the goals of effectuating the effective reorganization of business debtors — with the attendant preservation and expansion of jobs — and the maximization and realization of asset values for all creditors and stakeholders.”67 in cited 67  16 1, 20 ber 2 vem n No ed o rchiv 63 a -353 . 14 , No rown .B eth v Blixs See Commission’s mission statement, supra at 3. III. Background on the Commission and the Study Project Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 25 of 402 16 1, 20 ber 2 vem n No ed o rchiv 63 a -353 . 14 , No rown .B eth v Blixs IV. PROPOSED RECOMMENDATIONS: COMMENCING THE CASE in cited American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 26 of 402 Bankruptcy Institute The financially distressed company is typically the party that commences the chapter 11 case by filing a voluntary petition for relief under chapter 11 of the Bankruptcy Code. Although creditors may file an involuntary chapter 11 petition against a company under section 303 of the Bankruptcy Code, creditors rarely invoke this remedy.68 One study reported that involuntary bankruptcies “have represented less than one-tenth of one per cent of all U.S. liquidation bankruptcy cases for over a decade.”69 Creditors may consider an involuntary chapter 11 filing during their prepetition negotiations with a debtor. It is most common, however, for the debtor to then file a voluntary case or for the parties to reach an out-of-court resolution.70 Companies do not undertake a chapter 11 filing lightly. A company’s management is commonly concerned about the public nature of a chapter 11 case and the potential distractions to the business caused by enhanced oversight from the court, the U.S. Trustee, creditors, and other parties in interest.71 In fact, some commentators and practitioners suggest that financially distressed companies tend to wait too long to file a chapter 11 case, which makes it more difficult to use the restructuring tools of chapter 11 in an effective manner.72 Regardless, chapter  11 provisions should help companies achieve a “soft landing” in bankruptcy — i.e., minimize business disruptions to foster reorganization prospects — and develop a feasible restructuring strategy that benefits all stakeholders. Witnesses before the Commission testified concerning the various perceived barriers to successful reorganizations under chapter 11, including challenges to financing chapter 11 cases, uncertainty 6 and costs associated with the bankruptcy process, delays built into the process, and1insufficient value 1, 20 ber 2 available to support a restructuring.73 Some witnesses suggestednthatvem perceived barriers may No these do 74 e chivAnecdotal evidence likewise indicates cause companies to forego the chapter 11 process entirely. 3 ar 3536 . 14that distressed companies are increasinglyNturning to state law remedies (e.g., receiverships and , o own v. Br assignments for the benefit of eth creditors) and equity receivership law with more frequency now xs i in Bl cited 68 69 70 71 72 73 74  The Administrative Office of the U.S. Courts stopped collecting data on involuntary bankruptcies apparently because of their rarity. See Robert M. Lawless & Elizabeth Warren, The Myth of Disappearing Business Bankruptcy, 93 Cal. L. Rev. 743, 750 n. 11 (2005). Jason Kilborn & Adrian Walters, Involuntary Bankruptcy as Debt Collection: Multi-Jurisdictional Lessons in Choosing the Right Tool for the Job, 87 Am. Bankr. L.J. 123, 125 (2013). See Susan Block-Lieb, Why Creditors File So Few Involuntary Petitions and Why the Number Is Not Too Small, 57 Brooklyn L. Rev. 803, 805–06 (“Creditors file few involuntary petitions because they often prefer a negotiated resolution of a debtor’s financial troubles.”). See, e.g., Stephen J. Lubben, The Direct Costs of Corporate Reorganization: An Empirical Examination of Professional Fees in Large Chapter 11 Cases,74 Am. Bankr. L.J. 509, 543 (“The indirect costs [of chapter 11] . . . include loss in value due to managerial distraction, foregone investment opportunities, erosion of customer confidence, increases in employee turnover, and increased cost of supplier credit.”). See, e.g., Harner & Griffin, supra note 46, 324–38 (2014) (presenting empirical survey of 453 restructuring professionals and data showing that, of those professionals who had clients refuse to file a bankruptcy case at a time the professional thought advisable, 90 percent of those companies ultimately had to file a case). See generally supra note 66 and accompanying text (generally discussing limitations of chapter 11 empirical studies). See Oral Testimony of Josh Gotbaum: ACB Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 18 (Mar. 14, 2013) (ACB Transcript) (“[I]n many cases financial institutions and financial markets have outstripped the law’s ability to comprehend them and the bankruptcy court’s ability to preserve fair treatment of other constituencies in the face of them.”), available at Commission website, supra note 55; Oral Testimony of Wilbur Ross: ASM Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 4–7 (Apr. 19, 2013) (ASM Transcript) (discussing unpredictable cost increases in chapter 11), available at Commission website, supra note 55; Oral Testimony of the Honorable James Peck: VALCON Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 29–30 (Feb. 21, 2013) (VALCON Transcript) (discussing problems faced in some cases, including waste and delay as a result of valuation issues), available at Commission website, supra note 55. See Written Statement of John Haggerty, Argus Management Corp.: ASM Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (Apr. 19, 2013) (stating that a large majority of clients avoid chapter 11 and seek state law relief because of the costs, delay, structure of case administration, control by the secured creditor, and lack of flexibility attendant in a chapter 11 case), available at Commission website, supra note 55; Oral Testimony of John Haggerty, Argus Management Corp.: ASM Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 34–36 (Apr. 19, 2013) (ASM Transcript) (same), available at Commission website, supra note 55. IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 27 of Chapter  than in the past 75 years.75 Moreover, there is no meaningful way to discern how many distressed companies that could have used chapter 11 simply closed their doors instead of pursuing alternatives through the reorganization process. The Commission was very mindful of these considerations in reviewing issues relating to the filing, financing, and initial steps of a chapter 11 case. The principles in this section strive to address several of these issues. A. Oversight of the Case 1. The Debtor in Possession Model Recommended Principles: The ability of the debtor to act as a debtor in possession and assume the duties and powers of a trustee in bankruptcy is a central feature of chapter 11 of the Bankruptcy Code. It allows the debtor to continue its operations16 with minimal 20 r 21, disruptions while still serving the interests of the debtor’sbcreditors and, in many e ovem on N cases, its equity security holders as well. Accordingly, the debtor in possession ed rchiv 63 a model should continue as the default3rule under chapter 11. 4-35 .1 , No rown Applicable stateslaw v. B h fiduciary duties should continue to govern the conduct of the x et n Bli i debtor iindpossession’s board of directors, officers, or similar managing persons. c te For a discussion of directors’, officers’, and similar managing persons’ fiduciary duties in the plan context, see Section VI.A.2, Role of Debtor in Plan Process. The Debtor in Possession: Background A fundamental feature of chapter 11 of the Bankruptcy Code is the “debtor in possession” concept. This feature allows the financially distressed company to remain in control of its assets and to continue to operate its business after commencing the chapter 11 case. Accordingly, on the petition date, the company assumes the new legal capacity of a “debtor in possession.”76 In a typical chapter 11 case, the debtor in possession’s prepetition board of directors and officers will continue to manage the debtor’s affairs and make decisions regarding both the debtor’s business and its reorganization efforts in the chapter 11 case. The debtor in possession model was expanded by 75 76 Oral Testimony of Dan Dooley: ASM Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 36–39 (Apr. 19, 2013) (ASM Transcript) (discussing increased use of state law alternatives to chapter 11 such as local and state receiverships and assignments for the benefit of creditors (ABCs)), available at Commission website, supra note 55. For a further discussion of the use of receiverships, see Section VII.B, General Application of SME Principles. This Report refers only to the trustee in certain principles, and those references are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code. In addition, the Report discusses the implications of certain principles for debtors in possession, which likewise apply to any chapter 11 trustee appointed in the case. IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 28 of 402 Bankruptcy Institute chapter 11 in the 1978 Bankruptcy Code from the company’s active role in the rehabilitation process under Chapter XI (but not Chapter X) of the 1898 Bankruptcy Act.77 Practice under the Bankruptcy Act suggested that boards of directors and management resisted a process — even if arguably beneficial to their restructuring efforts — that required them to cede control of their business and restructuring efforts to an outside party. This requirement contributed in part to the failure of Chapter X of the Bankruptcy Act because it mandated the appointment of a trustee to run the debtor’s business and bankruptcy case.78 Notably, section 1107 of the Bankruptcy Code authorizes the debtor in possession to, among other things, exercise all “the rights . . . and powers, and [requires it to] perform all the functions and duties . . . of a trustee serving in a case under this chapter,” with only minor exceptions that do not detract from the central role of the debtor in possession in the case.79 Proponents of the debtor in possession model highlight the knowledge and expertise of the debtor’s prepetition directors, officers, or similar managing persons concerning the debtor’s business and financial affairs.80 The ability of the debtor in possession to continue to operate through its prepetition management team facilitates the company’s seamless transition into chapter 11 and allows the debtor to avoid the additional time, cost, and resulting inefficiencies of bringing in an outsider who is not familiar with the debtor’s business specifically or the debtor’s industry generally.81 The prepetition management team may also have industry relationships or “know-how” that would benefit the debtor’s restructuring efforts. 6 Critics of the debtor in possession model note that the debtor’s financial er 2operational difficulties or 1, 201 b may relate, at least in part, to the conduct or decisions of theon Novem prepetition directors and debtor’s d 82 chive team that was in charge during the officers. Some critics argue that allowing the management 3 ar 3536 . 14- rewards subpar performance and undermines debtor’s financial decline to remain in ncontrol , No ow v. Br for the debtor’s stakeholders.83 Some critics also worry that confidence in the reorganization tprocess eh Blixs prepetition management may be motivated by factors not necessarily aligned with the best interests ed in cit 77 78 79 80 81 82 83  See Clifford J. White III & Walter W. Theus, Jr., Chapter 11 Trustees and Examiners After BAPCPA, 80 Am. Bankr. L.J. 289, 292 n. 15 (2006) (“[T]he debtor generally remained in possession of its property and had all of the rights and powers of a trustee, subject to such limitations as the court might impose.”) (citations omitted). See generally John Wm. Butler, Jr., et al., Preserving State Corporate Governance Law in Chapter 11: Maximizing Value Through Traditional Fiduciaries, 18 Am. Bankr. Inst. L. Rev. 337 (2010) (detailing the history and role of the debtor in possession model in chapter 11). See H.R. Rep. No. 95-595, at 222, reprinted in 1978 U.S.C.C.A.N. 6182 (“Less than ten percent of all business reorganization cases are under Chapter X. Chapter XI is the much more popular procedure, even though what can be done under Chapter XI is less than under Chapter X.”) (citation omitted). See also Douglas E. Deutsch, Ensuring Proper Bankruptcy Solicitation: Evaluating Bankruptcy Law, the First Amendment, the Code of Ethics, and Securities Law in Bankruptcy Solicitation Cases, 11 Am. Bankr. Inst. L. Rev. 213, 217–18 (2003) (explaining debtors’ preference for Chapter XI under the Bankruptcy Act). The inflexible, mandatory absolute priority rule was also arguably a contributing factor to its failure. See Skeel, supra note 9, at 163 (“The draconian effect of Chapter X, together with the fact that so many large firms had already failed during the depression, caused a dramatic drop in Chapter X cases.”). 11 U.S.C. § 1107. See, e.g., In re Marvel Entm’t Grp., Inc., 140 F.3d 463, 471 (3d Cir. 1998) (“[V]ery often the creditors will be benefited by continuation of the debtor in possession, both because the expense of a trustee will not be required, and the debtor, who is familiar with his business, will be better able to operate it during the reorganization case.”). See H.R. Rep. No. 95-595, at 233, reprinted in 1978 U.S.C.C.A.N. 6192 (“A trustee frequently has to take time to familiarize himself with the business before the reorganization can get under way.”). See also David A. Skeel, Jr., Markets, Courts, and the Brave New World of Bankruptcy Theory, 1993 Wis. L. Rev. 465, 517 & n.188 (1993) (“In the nonclosely held firm context, immediate removal of management would create significant indirect costs both before and during the bankruptcy.”). See, e.g., A. Mechele Dickerson, The Many Faces of Chapter 11: A Reply to Professor Baird, 12 Am. Bankr. Inst. L. Rev. 109, 135 (2004) (“[T]here should be a rebuttable presumption that the directors of insolvent firms are unfit for board service and that they should be disqualified from future board service”); Lynn M. LoPucki, The Trouble with Chapter 11, 1993 Wis. L. Rev. 729, 732 n.11 (1993) (noting that prepetition management may pursue “directions that are not in economic interests of the company”). Written Testimony of the Honorable Joan N. Feeney: ASM Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 5 (Apr. 19, 2012) (citing a Cornell University study indicating that the strongest contributor to post-bankruptcy success is new management and arguing that bankruptcy judges need tools to deal with failed managers), available at Commission website, supra note 55. IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 29 of Chapter  of the estate, such as retaining their jobs or downplaying prepetition events that may implicate them in the debtor’s financial distress.84 Although the criticisms of the debtor in possession model raise some valid concerns, rather than being caused by management, a company’s chapter 11 filing is frequently triggered by a downturn in the overall economy, a fluctuation in markets particular to the debtor’s industry (e.g., pricing of a commodity necessary to the debtor’s operations), or a failed (but not negligent or fraudulent) business strategy. In these instances, the debtor’s management team typically maintains the confidence of the debtor’s stakeholders and can be an asset to the debtor’s reorganization efforts. Moreover, in some cases, the debtor may have replaced certain (or all) of its directors or officers either well before or shortly before filing in anticipation of the chapter 11 filing. These management changes may include the appointment of a chief restructuring officer who is often an experienced restructuring professional.85 Accordingly, the debtor’s management immediately preceding the petition date may be completely divorced from the decisions, actions, and circumstances that contributed to the debtor’s distress. The Bankruptcy Code also places certain checks on the debtor in possession’s power and decisionmaking authority in chapter 11. For example, the debtor in possession may be replaced by a trustee for cause; a statutory unsecured creditors’ committee frequently is appointed to oversee the debtor in possession’s conduct and to represent the interests of unsecured creditors; major decisions and 6 transactions require notice, hearing, and court approval; and the U.S.er 21, 201and parties in interest Trustee b em have standing to raise and be heard on matters in the case.86 Novaddition, the directors, officers, or n In ed o iv ar h similar managing persons of the debtor in possessioncare bound by their state law fiduciary duties.87 363 The Debtor -35 o. 14 n, N Brow th v. lixse in Possession: Recommendations in B cited and Findings The Commission considered the arguments in favor of and against the debtor in possession model. It also reviewed the potential alternatives to the debtor in possession model, which include the mandatory appointment of a trustee (as under Chapter X of the 1898 Bankruptcy Act), a receiver, or an administrator to replace the debtor’s management as of the petition date. In these alternative structures, management could stay in place and continue to work for the debtor, but it would be stripped of all management powers, which would then be vested in the trustee, receiver, or 84 85 86 87 See LoPucki, supra note 82, at 733 (“Because the[] [management] retain[s] the benefits of risk taking without suffering a corresponding share of the losses, it may be in their interests that the company take risks not justified by the expected returns to the company.”). See, e.g., Butler, et al., supra note 77, at 356 (“Employing turnaround professionals as CROs has become common in recent years. Often creditors insist that companies install third-party CROs in the midst of a dire financial situation.”). For a general discussion of the parties overseeing the debtor in possession in chapter 11, see Butler, et al., supra note 77. See also 11 U.S.C. § 1103 (detailing duties of statutory committees; id. § 1104 (appointment of trustee); id. § 1109 (explaining standing of parties in interest). Courts generally defer to the fiduciary duties of the debtor in possession’s directors and officers under applicable state law. See, e.g., In re Schipper, 933 F.2d 513, 515 (7th Cir. 1991) (applying state law fiduciary duties and rejecting common law or other duties akin to those of a trustee). The case law concerning the beneficiary of these duties is mixed, with some courts suggesting, for example, that the duties might be owed to the estate, specific creditors, or all creditors, while others again defer to state law. See, e.g., Petit v. New Eng. Mortg. Servs. Inc., 182 B.R. 64, 69 (D. Me. 1995) (quoting In re Ionosphere Clubs, Inc., 113 B.R. 164, 169 (Bankr. S.D.N.Y. 1990)) (“[D]ebtor in possession is a fiduciary of the creditors and, as a result, has an obligation to refrain ‘from acting in a manner which could damage the estate, or hinder a successful reorganization.’”) (citation omitted). See also In re Brook Valley VII, Joint Venture, 496 F.3d 892, 900 (8th Cir. 2007) (“Debtors in possession and those who control them owe fiduciary duties to the bankruptcy estate. The fiduciary obligations consist of two duties: the duty of care and the duty of loyalty.”); In re Coram Healthcare Corp., 271 B.R. 228, 235 (Bankr. D. Del. 2001) (“The DIP must not self-deal, cannot act with a conflict of interest and must not take actions which are improper.”). As explained below, the Commission addressed these issues in its deliberations. IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 30 of 402 Bankruptcy Institute administrator. Moreover, the trustee, receiver, or administrator could terminate the employment of the debtor’s management altogether. The Commissioners debated the potential utility of a third-party manager to the bankruptcy estate. The Commission determined that these third-party alternatives could add the most value to cases involving fraudulent or incompetent management. The Commissioners acknowledged, as discussed further below, that section 1104 of the Bankruptcy Code currently mandates the appointment of a trustee in such cases.88 The Commission also considered that in recent years many countries have adopted some form of the debtor in possession model either in lieu of or as an alternative (at the company’s election) to a receiver or administrator.89 This trend suggests broad recognition of the potential benefits of allowing the honest-but-unfortunate company debtor to lead its own restructuring efforts. Thus, on balance, the Commission concluded that the potential value of a mandatory trustee-like actor was significantly outweighed by the potential disruption, costs, and inefficiencies associated with the displacement of the debtor’s management. Accordingly, the Commission recommended retention of the debtor in possession model. As part of that decision, the Commission also agreed that directors, officers, and similar managing persons who operate a business in chapter 11 should remain subject to their state law fiduciary duties.90 The Commissioners analyzed whether creating a new fiduciary standard under federal bankruptcy law would better serve the purposes of the Bankruptcy Code. Any federal standard 6 would incorporate the traditional duties of care and loyalty, as well as good r 21, 2either as a subset of faith 01 be vem the duty of loyalty or an independent duty.91 As the Commissionersodiscussed this possibility, they nN ed o recognized significant value in aligning the fiduciary 363 archivthe debtor in possession’s management duties of 35 . 14- consistency to the process and is informed by the with state law fiduciary duties. This approach o , N lends own v. Brfiduciary duties. wealth of case law discussing state law h xset i in Bl cited 88 89 90 91  11 U.S.C. § 1104(a) (providing that, upon the request of a party in interest or the U.S. Trustee, the court shall appoint a trustee “for cause, including fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor by current management, either before or after the commencement of the case, or similar cause”) (emphasis added). In addition, section 1104(e) provides: “The United States trustee shall move for the appointment of a trustee under subsection (a) if there are reasonable grounds to suspect that current members of the governing body of the debtor, the debtor’s chief executive or chief financial officer, or members of the governing body who selected the debtor’s chief executive or chief financial officer, participated in actual fraud, dishonesty, or criminal conduct in the management of the debtor or the debtor’s public financial reporting.” 11 U.S.C. § 1104(e). See, e.g., Business Continuity Act of 31 Jan. 2009 (Belgium: debtor remains in control during moratorium period with limited control by the court); Companies’ Creditors Arrangement Act (Canada: debtor remains in control and is assisted by a courtappointed monitor frequently selected by the debtor); Insolvenzordnung, German Insolvency Act §§ 80, 270 (Germany: provides for “self-administration” in which the debtor works to reorganize under the surveillance of a supervisor; debtor may elect selfadministration provided that there are “no facts known which give reason to expect that the order will lead to disadvantages to the creditors”); Civil Rehabilitation Act (Japan: debtor remains in control and is monitored by a supervisor). This Report refers to “applicable state entity governance law” to capture not only state corporate law, but also applicable state law governing unincorporated entities (e.g., partnerships, limited liability companies, etc.). In addition, references to “board of directors” and “directors, officers, and similar managing persons” are intended to refer to the individuals or entities acting on behalf of unincorporated entities in capacities similar to those of the board, directors, and officers in the corporate context. See, e.g., Lange v. Schropp (In re Brook Valley VII, Joint Venture), 496 F.3d 892, 900 (8th Cir. 2007) (explaining that, in the bankruptcy context, “[t]he fiduciary obligation consists of two duties: the duty of care and the duty of loyalty”); Ad Hoc Comm. of Equity Holders of Tectonic Network, Inc. v. Wolford, 554 F. Supp. 2d 538, 558 n.135 (D. Del. 2008) (duty of good faith is a subset of the duty of loyalty in the bankruptcy context); Unif. P’ship Act § 404 (1997) (fiduciary duties of partners in partnership). See also Gantler v. Stephens, 965 A.2d 695, 708–09 (Del. 2009) (“In the past, we have implied that officers of Delaware corporations, like directors, owe fiduciary duties of care and loyalty, and that the fiduciary duties of officers are the same as those of directors. We now explicitly so hold.”) (citation omitted); Stone v. Ritter, 911 A.2d 362, 369–70 (Del. 2006) (“The failure to act in good faith may result in liability because the requirement to act in good faith ‘is a subsidiary element[,]’ i.e., a condition, ‘of the fundamental duty of loyalty.’”) (quoting Guttman v. Huang, 823 A.2d 492, 506 n.34 (Del. Ch. 2003)); Lyman P.Q. Johnson & Mark A. Sides, The Sarbanes-Oxley Act and Fiduciary Duties, 30 Wm. Mitchell. L. Rev. 1149, 1205–06 (2004) (“Although often overlooked, corporate officers, including senior officers such as the Chief Executive Officer, the Chief Financial Officer, Chief Technology Officer, General Counsel, Executive Vice Presidents, the Treasurer, the Secretary, and others are ‘agents’ of the corporation. Agency is a fiduciary relationship. Even though senior officers of corporations typically have employment agreements, they still occupy a fiduciary status in relation to the corporate principal.”) (citations omitted). IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 31 of Chapter  The Commissioners also discussed the potential conflicts in duties that could result from federalizing the fiduciary duties of directors, officers, and similar managing persons. For example, most state laws provide that directors, officers, and similar managing persons owe a fiduciary duty to the company, which is enforceable by its shareholders when the company is solvent and also by its creditors when it is insolvent.92 Some courts have suggested that this allocation of rights between shareholders and creditors shifts as a company approaches insolvency (i.e., the “zone of insolvency”), but many courts tend to maintain the status quo until the company becomes insolvent.93 If the Bankruptcy Code imposed separate duties on a debtor in possession’s directors, officers, or similar managing persons, those duties might differ from the duties owed by those individuals under state law. Although federal preemption principles might resolve such conflicts from a legal perspective, the conflict could cause substantial confusion and uncertainty for directors, officers, and similar managing persons. The Commission agreed that state law adequately governs fiduciary duties and should continue to govern the fiduciary duties of directors, officers, and similar managing persons in bankruptcy. 92 93 See United States v. Byrum, 408 U.S. 125, 138 (1972) (“[T]he directors . . . have a fiduciary duty to6 promote the interests of the 201 corporation.”); N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 99 (Del. 2007) (“It is well established r 21, b that the directors owe their fiduciary obligations to the corporation and its shareholders.e); Revlon, Inc. v. MacAndrews & Forbes ovem ” Holdings, Inc., 506 A.2d 173, 179 (Del. 1986) (“[T]he directors owe fiduciary duties of care and loyalty to the corporation and its on N ved shareholders.”); Woodward v. Andersen, 627 N.W.2d 742, 751 (Neb. i2001) (“An officer or director of a corporation . . . occupies arch 363 a fiduciary relation toward the corporation and its stockholders, and is treated by the courts as a trustee.”). See, e.g., N. Am. 4-35 Catholic Educ. Programming Found., Inc. v.n, No. 1 930 A.2d 92, 101 (Del. 2007) (“When a solvent corporation is navigating Gheewalla, in the zone of insolvency, the focus v. Brow for Delaware directors does not change: directors must continue to discharge their fiduciary duties to the corporation andseth lix its shareholders by exercising their business judgment in the best interests of the corporation for in B the benefit of its shareholder owners.”); Quadrant Structured Prods. Co. v. Vertin, 2014 Del. Ch. LEXIS 193, at *58 (Del. Ch. cited Oct. 1, 2014) (“In a solvent corporation, the standard of conduct for directors requires that they strive in good faith and on an informed basis to maximize the value of the corporation for the benefit of its residual claimants, the ultimate beneficiaries of the firm’s value. In a solvent corporation, the residual claimants are the stockholders. Consequently, in a solvent corporation, the standard of conduct requires that directors seek prudently, loyally, and in good faith to manage the business of a corporation for the benefit of its shareholder owners.”); In re Bear Stearns Litig., 23 Misc. 3d 447, 475 (N.Y. Sup. Ct. 2008) (“The directors still have the ‘duty to maximize the value of the insolvent corporation for the benefit of those having an interest in it’ and are required to ‘engage in vigorous, good faith negotiations with individual creditors for the benefit of the corporation.’”) (citing N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 103 (Del. 2007)); Dodge v. Ford Motor Co., 170 N.W. 668, 684 (Mich. 1919) (“A business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end. The discretion of directors is to be exercised in the choice of means to attain that end, and does not extend to a change in the end itself, to the reduction of profits, or to the nondistribution of profits among stockholders in order to devote them to other purposes.”). See also James Gadsden, Enforcement of Directors’ Fiduciary Duties in the Vicinity of Insolvency, Am. Bankr. Inst. J., Feb. 2005, at 16 (“The corporation laws of all states agree that directors owe fiduciary duties to the corporation.”); Royce de R. Barondes, Fiduciary Duties of Officers and Directors of Distressed Corporations, 7 Geo. Mason L. Rev. 45, 63 (1998) (explaining that when the corporation reaches insolvency, “[t]he majority rule, and the law in Delaware, is that . . . a board’s duties are owed to the creditors of the enterprise”); Bruce A. Markell, The Folly of Representing Insolvent Corporations: Examining Lawyer Liability and Ethical Issues Involved in Extending Fiduciary Duties to Creditors, 6 Norton J. Bankr. L. & Prac. 403, 404 (1997) (“Indeed, [when a company is solvent], most states impose fiduciary duties of loyalty and care on the directors and officers in favor of shareholders.”); Ramesh K.S. Rao, et al., Fiduciary Duty a la Lyonnais: An Economic Perspective on Corporate Governance in a Financially-Distressed Firm, 22 J. Corp. L. 53, 64 (1996) (explaining that “[a]s the firm slides into insolvency,” fiduciary responsibilities are “extended to creditors in order to ensure adequate protection of their interests”); Jeffrey N. Gordon, Corporations, Markets, and Courts, 91 Colum. L. Rev. 1931, 1977 (1991) (shareholder wealth maximization is “the bedrock of corporate law”). But see Margaret M. Blair & Lynn A. Stout, Specific Investment: Explaining Anomalies in Corporate Law, 31 J. Corp. L. 719, 731 (2006) (“There is very little in corporate law that supports [shareholder wealth maximization] and much that cuts against it.”). See, e.g., Berg & Berg Enters., LLC v. Boyle, 100 Cal. Rptr. 3d 875, 894 (Ct. App. 2009) (“[W]e hold that there is no fiduciary duty prescribed under California law that is owed to creditors by directors of a corporation solely by virtue of its operating in the ‘zone’ or ‘vicinity’ of insolvency.”) (using the trust fund doctrine to determine the directors’ fiduciary duties); N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007). But see Geiger & Peters, Inc. v. Berghoff, 854 N.E.2d 842, 850 (Ind. Ct. App. 2006) (“Indiana does not adhere to the ‘trust fund’ theory. . . .”); St. James Capital Corp. v. Pallet Recycling Assocs. of N. Am., Inc., 589 N.W.2d 511, 516 (Minn. Ct. App. 1999) (“‘Corporate property is not held in trust’. . . . [C]reditors have the right to be repaid, [but] it is equally true that they do not have the right, absent an agreement to the contrary, to dictate what course of action the directors and officers of a corporation shall take in managing the company. . . .”) (citation omitted). IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 32 of 402 Bankruptcy Institute 2. The Chapter 11 Trustee Recommended Principles: The standard for appointing a chapter 11 trustee under section  1104(a) of the Bankruptcy Code should not change. The burden of proof with respect to requests for the appointment of a chapter 11 trustee under section 1104(a) should be based on the preponderance of the evidence standard. Case law requiring application of the clear and convincing standard should be overturned by statutory amendment. As is currently provided by section 1104(d), the U.S. Trustee should continue to select and appoint a disinterested person to serve as chapter 11 trustee after the court enters an order under section 1104(a) directing such appointment and after consultation with parties in interest.94 A party in interest should be able to object to the person appointed as the chapter 11 trustee. An objecting party should plead with particularity the facts supporting its objection. The objection should be filed and heard on an expedited basis. The court 16 should approve the person appointed by the U.S. Trustee unless the2objecting party 1, 20 ber did not properly m establishes by clear and convincing evidence that: (1) the U.S.oTrustee N ve d n eis o eligible to serve as trustee consult with parties in interest; (2) the person selected not rchiv 63 a -353 not qualified to serve as trustee under under section 321; (3) the person selected has . 14 , No rown is not disinterested; or (5) the person selected has B section 322; (4) the person.selected hv xset n Bli i a disqualifying conflict of interest. If an objection is filed, the court should approve cited or disapprove the person appointed as chapter 11 trustee by the U.S. Trustee, but the court should not otherwise be involved in the chapter 11 trustee selection process. Section 1104(b), which provides for the election of a chapter 11 trustee, should be deleted. Once appointed, the chapter 11 trustee may take any actions and exercise any powers with respect to the estate as authorized under section 1106 without the approval or consent of the debtor, the debtor’s board of directors (or similar governing body), any of the debtor’s officers or similar managing persons, or the debtor’s equity security holders. The appointment of a chapter 11 trustee should not terminate the debtor’s exclusivity period to file, or its time to solicit acceptances of, a plan, but should preserve such exclusivity period solely for the benefit of the trustee. Accordingly, the trustee should receive the benefit of any remaining exclusivity period under section 1121, provided that a party in interest should be able to file a motion seeking to shorten or terminate such period as provided in section 1121(d). Section 1121(c)(1) should be amended accordingly. 94  Bankruptcy cases in Alabama and North Carolina are not under the jurisdiction of the U.S. Trustee, but rather are administrated by Bankruptcy Administrators in those jurisdictions. Accordingly, the applicable rules of those jurisdictions would govern the appointment process. IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 33 of Chapter  The Chapter 11 Trustee: Background A trustee is appointed in a chapter 11 case only upon a motion of a party in interest or the U.S.  Trustee and the entry of an order of the court granting such motion. Section 1104 of the Bankruptcy Code provides that the court shall order the appointment of a trustee “for cause, including fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor by current management” or “if such appointment is in the interests of creditors, any equity security holders, and other interests of the estate.”95 In addition, section 1104(e) requires the U.S. Trustee to file a motion requesting a trustee “if there are reasonable grounds to suspect that current [management] . . . participated in actual fraud, dishonesty, or criminal conduct in the management of the debtor or the debtor’s public financial reporting.”96 Notwithstanding this statutory authority, anecdotal evidence suggests that chapter 11 trustees are the rare exception rather than the rule.97 The paucity of cases in which chapter 11 trustees serve may suggest that the overall system is working and that stakeholders either have confidence in the debtor’s management or have replaced troublesome managers prior to or shortly after the petition date.98 Parties in interest may also be using the possibility of seeking the appointment of a trustee in negotiations with the debtor in a way that fosters meaningful results and eliminates the need for a trustee.99 A case warranting a chapter 7 trustee may convert to a case under chapter 7 of the Bankruptcy Code, thereby eliminating the need for a chapter 11 trustee.100 Some contend 16 that a systemic antipathy to reorganization trustees, arising from pre-Bankruptcy Code practice, 1, 20 ber 2 ve of found its way into early decisions that construed the language m the Bankruptcy Code.101 For n No ed o example, courts may be discouraging parties fromarchiv motions requesting the appointment of a filing 63 -353 chapter 11 trustee by applying the clearoand convincing standard to the determination.102 Parties . 14 ,N rown by the debtor or other stakeholders if the court denies the B in interest also may fear retribution h v. xset n Bli motion, or may cited i having individuals with whom they are familiar (even if they do not like or prefer necessarily trust them) rather than an individual they do not know. Moreover, some parties may raise concerns regarding the costs associated with chapter 11 trustees, which may be driven by a perception that chapter 11 trustees are inclined toward litigation to ensure that they fulfill their fiduciary duties to the estate.103 If the court enters an order appointing a chapter 11 trustee, the U.S. Trustee identifies a disinterested and qualified individual to serve as the trustee.104 Section 1104(d) requires the U.S. Trustee to 95 96 97 98 99 100 101 102 103 104 11 U.S.C. § 1104(a)(1), (2). Id. § 1104(e). See, e.g., Dickerson, supra note 19, at 888–900 (explaining that “[t]hough the Code provides that managers can be replaced or supervised by a public trustee, trustee appointments are, and always have been, rare”); Kelli A. Alces, Enforcing Corporate Fiduciary Duties in Bankruptcy, 56 U. Kan. L. Rev. 83, 84–85 (2007) (noting rarity of chapter 11 trustees). See, e.g., John D. Ayer, et al., Bad Words to a Debtor’s Ear, Am. Bankr. Inst. J., Mar. 2005, at 20 (“Creditors force out the old management before the chapter 11 begins, and so the nominal ‘DIP’ is someone in whom creditors have faith, sent in to clean up the mess that others left behind.”). See, e.g., Stuart C. Gilson & Michael R. Vetsuypens, Creditor Control in Financially Distressed Firms: Empirical Evidence, 72 Wash. U. L.Q. 1005, 1012 (1994) (discussing creditors’ threats to petition the court to appoint a trustee if managers do not resign). See, e.g., Ayer et al., supra note 98. Clifford J. White III & Walter W. Theus, Jr., Chapter 11 Trustees and Examiners after BAPCPA, 80 Am. Bankr. L. J. 289, 314–15 (2006). See, e.g., In re G-I Holdings, Inc., 385 F.3d 313 (3d Cir. 2004) (applying clear and convincing standard). But see Tradex Corp. v. Morse, 339 B.R. 823 (D. Mass. 2006) (applying preponderance of the evidence standard). In addition, the increasing use of chief restructuring officers, at least in larger chapter 11 cases, may suggest that parties are working around the concerns often associated with chapter 11 trustees. See Clifford J. White III & Walter W. Theus, Jr., Taking the Mystery Out of the Chapter 11 Trustee Appointment Process, Am. Bankr. Inst. J, May 2014 (“Beyond independence, the U.S. Trustee will consider a candidate’s experience, qualifications and ability to IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 34 of 402 Bankruptcy Institute consult with parties in interest during this process, and the selection is subject to court approval.105 Although section 1104(d) is silent on the scope of court review, the court generally will review only whether the U.S. Trustee consulted with parties as required by the Bankruptcy Code and whether the candidate is disinterested and is formally qualified to serve as trustee. A party in interest may also request that the U.S. Trustee hold an election for the trustee in accordance with section 702 of the Bankruptcy Code.106 Once identified and approved, the chapter 11 trustee assumes all of the powers of the debtor’s management, is vested with certain other powers, and is subject to certain duties under section 1106 of the Bankruptcy Code. The trustee can, among other things, operate the debtor’s business, manage and administer the bankruptcy estate, file and implement a chapter 11 plan, and investigate the debtor’s affairs and prepetition activities.107 The trustee must also ensure that certain materials and reports are filed with the court on a timely basis. The Chapter 11 Trustee: Recommendations and Findings The debtor in possession model should not be the sole structure for a chapter 11 case. The Bankruptcy Code needs an effective mechanism for appointing a chapter 11 trustee to displace management in appropriate cases. The Commissioners discussed the kinds of cases that warrant chapter 11 trustees, including instances of fraud or illegal conduct by management. 016 They also acknowledged the value of appointing a trustee to increase ber 21, 2 accountability in chapter m Nove 11 cases, to protect against “bankruptcy rings” and collusive nconduct, and to create dynamic ed o rchiv tension by introducing an outsider to the negotiationaprocess.108 As referenced in the previous 63 -353 14 section, however, the CommissionersoalsoNo. , evaluated the potential disadvantages of appointing a r wn v. B trustee, such as the potentialxcollateral impact of the appointment, additional costs, delays, and seth n Bli ted i inefficiencies in thecicase. In light of the foregoing, the Commission determined to retain the grounds for the appointment of a chapter 11 trustee set forth in section 1104(a) because they are warranted and strike an appropriate balance between the benefits and drawbacks of such appointment. The Commission also considered the relatively low percentage of trustee appointments in chapter 11 cases. It was not able to determine if the relatively small number of trustee appointments suggested a flaw in the current system or reflected the judgment of stakeholders that grounds either did not exist to support an appointment or were remedied through prepetition changes 105 106 107 108  muster necessary bankruptcy, financial and business expertise.”). Bankruptcy cases in Alabama and North Carolina are not under the jurisdiction of the U.S. Trustee, but rather are administrated by Bankruptcy Administrators in those jurisdictions. 11 U.S.C. § 1104(a). See also Chapter 11 Trustee Handbook 7 (May 2004) (explaining that the U.S. Trustee consults, either by telephone or in person, with parties in interest to identify candidates and then interviews potential candidates to determine if they are qualified for the particular case and disinterested); White & Theus, supra note 104 (“Once the court enters the order, the U.S. Trustee expeditiously consults with major creditors, the creditors’ committee, the debtor and other interested parties. This consultation might be in person, by telephone or by email. U.S. Trustees take seriously and place a high value on the input provided by parties in interest.”). 11 U.S.C. § 1104(b) (providing that motion requesting an election must be filed within 30 days of the entry of the order appointing a chapter 11 trustee). Id. § 1106(a). For a historical overview of the purpose of the U.S. Trustee in response to so-called “bankruptcy rings,” see 6  Collier On Bankruptcy ¶ 6.01 (Alan N. Resnick & Henry J. Sommer eds., 16th ed.) (“[I]n many parts of the country, the Bankruptcy Act principle of creditor control of cases had degenerated into a system of attorney control. That fostered the development of ‘bankruptcy rings,’ closed bankruptcy practices heavily favoring the appointment of insiders, who were obliged to one another, to trustee positions. Cases were too often administered solely for the benefit of the members of the bankruptcy rings, with creditors receiving nothing.”). IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 35 of Chapter  in management. The Commissioners were persuaded by the suggestion that the burden of proof governing a motion to appoint a chapter 11 trustee under section 1104 could influence the decision of a party in interest to file such a motion in the first place. Indeed, courts often expressly state that the appointment of a chapter 11 trustee is the exception and that the standard for approval is very high.109 The Commissioners evaluated the potential chilling effect of requiring the moving party to demonstrate the need for a trustee by clear and convincing evidence and the justifications for this standard.110 They also discussed whether a lower standard, such as the preponderance of the evidence standard, could be subject to abuse and cause unnecessary distractions in the chapter 11 case. The Commissioners carefully weighed the competing considerations and relevant policy objectives underlying the debtor in possession model and the Bankruptcy Code. Reflecting on the discussion of cases that may warrant and benefit from a trustee, the Commission determined that the lower preponderance of the evidence standard — and not the clear and convincing evidence standard — should apply to motions to appoint a chapter 11 trustee under section  1104(a). This change is likely to not only encourage parties in interest to seek the appointment of a chapter 11 trustee in appropriate cases, but it would also resolve a split among the courts on this important legal issue. The Commissioners also discussed their various experiences with trustees in chapter 11 cases and 6 acknowledged that, particularly in cases involving massive fraud by the 1, 201 chapter 11 trustees debtor, ber 2 em have served with distinction.111 They discussed the value of havingvthe U.S. Trustee, as an independent n No ed o r hiv agency with no financial stake in the case, identify cand vet trustee candidates, because multiple 63 a -353 o. 1 in stakeholders may have competing interests 4 the selection process. n, N h v. xset n Bli i Brow The Commissionted ci reviewed at length the current consultation process and believed that the U.S. Trustee should, as under current law, continue to consult with parties in interest to both identify potential candidates and to better understand the needs and circumstances of the particular case. The Commission did not find any value in imposing a public meeting requirement on the trustee selection process; rather, all evidence indicates that the private consultation practice currently in place works well, and imposing a public meeting requirement is likely to add cost and delay to the process and to chill participation and openness. The Commission considered whether the election process incorporated into section  1104(b) provides stakeholders with a sufficient alternative to a candidate selected by the U.S. Trustee. In theory, the election process should enable stakeholders to nominate directly and then to vote on 109 See, e.g., In re Taub, 427 B.R. 208, 225 (Bankr. E.D.N.Y. 2010) (“The appointment of a trustee is an unusual remedy and ‘[t]he standard for § 1104 appointment is very high. . . .’”) (quoting Adams v. Marwil (In re Bayou Grp., LLC), 564 F.3d 541, 546 (2d Cir. 2009)). 110 See, e.g., In re LHC, LLC, 497 B.R. 281, 291 (Bankr. N.D. Ill. 2013) (“Applying the clear and convincing evidence standard appears . . . to be more consistent with the presumptions that a debtor should generally be permitted to remain in control and possession of its business and that the appointment of a Chapter 11 trustee is an extraordinary remedy.”) (citation omitted). 111 But see Written Statement of Daniel Kamensky on behalf of Managed Funds Association: LSTA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (Oct. 17, 2012) (“MFA therefore suggests that Congress should make clear that parties in interest and the U.S. Trustee may seek appointment of a trustee in circumstances other than fraud – where management entrenchment, misalignment of interests or other factors have significantly impaired the reorganization process such that a neutral third party is necessary to break the logjam. Appointment of a trustee should be authorized if the court believes that a trustee will be better equipped than management to navigate competing interests and facilitate a successful reorganization. The preference of all creditors should be taken into account – both in the appointment of an interim trustee and in any subsequent election.”). IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 36 of 402 Bankruptcy Institute qualified candidates. Unfortunately, the anecdotal evidence suggests that stakeholders rarely request an election process and are skeptical that the process benefits the estate for at least two reasons. First, it is hard to displace a trustee that has already been put in place, even if a different person with greater support among the constituents might have been picked in the first instance. Second, several of the major constituencies are not entitled to vote under section 1104(b), including secured creditors and unions.112 The Commissioners found the election process unsatisfactory in light of these concerns. Consequently, the Commission considered alternative ways to provide all stakeholders with a stronger voice in the trustee-selection process, based on the belief that such a process may further mitigate any resistance to trustee appointment in appropriate cases. The Commissioners discussed a variety of ways to allow stakeholders to voice objections to trustee candidates and to have some role in the selection process. In exploring these alternatives, the Commissioners were very mindful of the need for the U.S. Trustee to maintain flexibility and discretion as the independent appointing official. Allowing the court or stakeholders to second-guess the U.S. Trustee’s decision too easily could come with substantial costs, including introducing bias into the process and paralyzing the debtor’s reorganization efforts while parties in interest attempt to agree on a trustee candidate. Section 1104(d) provides for court approval of the U.S. Trustee’s trustee appointments, but does not specify any grounds upon which the court may disapprove an appointment. Furthermore, parties 16 in interest are given no role in the appointment approval process. TheerCommission concluded 1, 20 b 2 that specifying grounds for disapproval and providing stakeholdersovem a more defined ability to N with d on chive The Commissioners explored how object to the U.S. Trustee’s appointment would be 3beneficial. 3 ar 35 6 . 14to discourage frivolous objections and tonencourage full disclosure in a manner that informed the , No ow v. Brrelevant to the appointment of the trustee. The Commission parties and the court about the eth issues Blixs determined that anyciobjections should be pled with particularity and that the objection process ed in t should incorporate a strong presumption favoring the U.S. Trustee’s candidate. The court should approve the person appointed by the U.S. Trustee unless the objecting party establishes by clear and convincing evidence that: (1) the U.S. Trustee did not properly consult with parties in interest; (2) the person selected is not eligible to serve as trustee under section 321 of the Bankruptcy Code; (3) the person selected has not qualified to serve as trustee under section 322 of the Bankruptcy Code; (4) the person selected is not disinterested; or (5) the person selected has a disqualifying conflict of interest. A court should not reject the U.S. Trustee’s selection based on a party in interest’s assertion that another individual would better serve the estate or is better qualified for the position. Moreover, neither the court nor the objecting party should be able to displace the U.S. Trustee in the appointment process. The court should only be able to approve or disapprove the U.S. Trustee’s appointment. If the court disapproves an appointment, the U.S. Trustee should still maintain control of the appointment process by vetting additional candidates and making a substitute appointment. Once a chapter 11 trustee has been appointed, the Commission found that the current process works for vesting the trustee with all control and management authority concerning the debtor and the estate. Specifically, if grounds exist to warrant the appointment, the chapter 11 trustee 112 Eligibility to vote for the trustee is determined by section 702 of the Bankruptcy Code. In order to vote, creditors must, among other things, hold an allowable undisputed, fixed, liquidated, and unsecured claim. Secured creditors are thus not eligible to vote because their claim is not unsecured, and unions are frequently not eligible to vote because their claims are contingent, disputed, or unliquidated.  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 37 of Chapter  should be able to take any actions and exercise any powers with respect to the estate as authorized under section 1106 without the approval or consent of the debtor, the debtor’s board of directors (or similar governing body), any of the debtor’s officers or similar managing persons, or the debtor’s equity security holders. Accordingly, the chapter 11 trustee should, for example, be able to cause the estate to retain managers and employees deemed necessary to the reorganization process, but such personnel should act only under the supervision of the trustee. The Commissioners debated whether the debtor’s exclusivity periods to file a plan and solicit acceptances of a plan should terminate upon the appointment of a trustee. The Commissioners explored why termination may be appropriate; indeed, displacement of the debtor’s management suggests a need for different approaches to the reorganization, and stakeholders should have some say in the new process. The trustee, however, is appointed in large part to facilitate this new direction and should have some ability to negotiate with the various stakeholders to try to reach a resolution that benefits the estate and its stakeholders. Accordingly, the Commission determined that if the debtor has any remaining exclusivity periods under section 1121 at the time of the trustee’s appointment, the trustee should be able to step into the shoes of the debtor and receive the benefit of such remaining exclusivity periods, but should not be able to seek extensions of those periods. In discussing the chapter 11 trustee appointment process, as well as the estate neutral appointment process described below, the Commission considered the current dual system for bankruptcy 16 administration: (i) U.S. Trustees for 48 states, Puerto Rico, the U.S. Virgin2Islands, and Guam; and 1, 0 ber 2 vem (ii) Bankruptcy Administrators for Alabama and North Carolina. The Office of the U.S. Trustee n No ed o rc v operates as a division of the Department of Justice,hiand the Executive Office for U.S. Trustees 63 a -353 coordinates and oversees the activitiesNof. 14 U.S. Trustees in 21 regional offices.113 This structure , o the own v. Br promotes uniformity andxconsistency in the application of federal bankruptcy laws. The Bankruptcy eth Bli s Administrator programs are separately administered in each state through the judiciary in those ed in cit states.114 The Commissioners debated the efficiency of continuing these two separate systems. Some Commissioners believed that unifying the administration and oversight of bankruptcy cases in all jurisdictions under the Office of the U.S. Trustee would promote the uniformity in the application of federal bankruptcy laws as envisioned by the Bankruptcy Clause of the Constitution115 and would serve the interests of parties in the system. They encouraged the Commission to recommend making the U.S. Trustee program a national program that would be responsible for bankruptcy administration in all 50 states, as well as Puerto Rico, the U.S. Virgin Islands, and Guam. Other Commissioners expressed a concern that this issue was not directly within the scope of the Commission’s mandate. Consequently, the Commission decided not to address this matter. 113 For more information about U.S. Trustees and the Executive Office for the U.S. Trustees, see U.S. Trustee Program, http://www. justice.gov/ust/index.htm. 114 For more information about Bankruptcy Administrators, see Bankruptcy Administrators, http://www.uscourts.gov/ FederalCourts/Bankruptcy/BankruptcyAdministrators.aspx. 115 U.S. Const. art. I, § 8, cl.4. See also Charles Jordan Tabb, The Bankruptcy Clause, the Fifth Amendment, and the Limited Rights of Secured Creditors in Bankruptcy, 2015 Ill. L. Rev. __, at *1 (forthcoming 2015) (noting that the powers granted to Congress under the Bankruptcy Clause are extremely broad), available at http://ssrn.com/abstract=2516841. IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 38 of 402 Bankruptcy Institute 3. The Estate Neutral Recommended Principles: The Bankruptcy Code should be amended to delete any reference to an “examiner” and to incorporate the concept of a more flexible “estate neutral,” as described in these principles. Section 1104(c) of the Bankruptcy Code should be amended to set forth the standards for, and potential authority and duties of, an estate neutral, as described in these principles. Section 1104(c) should not mandate the appointment of an estate neutral in any circumstances. The court should be permitted to order the U.S. Trustee to appoint an estate neutral if (i) a trustee is not appointed and (ii)(a) the appointment is in the best interests of the estate, or (b) for cause.116 An order directing the U.S. Trustee to appoint an estate neutral should specify the scope of the estate neutral’s duties and the duration of the appointment. The court 6 may direct the U.S. Trustee to appoint more than one estate neutral 201any given , in er 21 bthe circumstances case to serve different functions if necessary or warranted em v by n No ed o of the case. Nevertheless, the Bankruptcy Codeivshould include a presumption rch 63 a -353estate neutral in any given case. against the appointment of more No. 14one than wn, . Bro eth vU.S. Trustee to appoint an estate neutral should not An order directing sthe Blix ed in citindividual to: (i) propose a chapter 11 plan for the debtor; (ii) act as permit that a mediator in any matter affecting the chapter 11 case, unless such action is the primary purpose of the individual’s original appointment; (iii) initiate litigation on behalf of the debtor or the estate, unless such action is within the scope of the individual’s original appointment and the individual was not previously engaged to investigate or examine matters relating to the litigation or the debtor’s chapter 11 case; or (iv) except as provided in the principles for small and medium-sized enterprise cases, operate the debtor’s business. Upon the entry by the court of an order directing the U.S. Trustee to appoint an estate neutral, the U.S. Trustee should, in conformity with the procedures established for the appointment of a chapter 11 trustee, appoint a disinterested person to serve as the estate neutral. A party in interest should have the ability to object to the person appointed as the estate neutral under the same procedures and subject to the same standards established in the principles governing objections to the person appointed as the chapter 11 trustee. See Section IV.A.2, The Chapter 11 Trustee. 116 Bankruptcy cases in Alabama and North Carolina are not under the jurisdiction of the U.S. Trustee, but rather are administrated by Bankruptcy Administrators in those jurisdictions. Accordingly, the applicable rules of those jurisdictions would govern the appointment process.  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 39 of Chapter  The Estate Neutral: Background A chapter 11 trustee is not the only alternative to the debtor in possession. An examiner with a specific directive may be appointed to investigate the affairs of the debtor.117 An examiner does not displace the debtor in possession or its management, and it is available only if no trustee has been appointed and only upon request of a party in interest or the U.S. Trustee and after notice and a hearing. In those circumstances, section 1104(c) requires the court to appoint an examiner if such appointment is in the interests of creditors, equity security holders, or the estate, or if “the debtor’s fixed, liquidated, unsecured debts, other than debts for goods, services, or taxes, or owing to an insider, exceed $5,000,000.”118 Whether the appointment of an examiner is truly mandatory in any given case has met with resistance by some courts and created a split in the law.119 Professor Jonathan C. Lipson reviewed “dockets from 576 of the largest chapter 11 cases commenced between 1991 and 2007” and discovered that “examiners were requested in only 87 cases, or about 15 percent of the sample,” and that the “motions were granted in only 39 cases, less than half of cases where [an examiner was] sought, and about 6.7 percent of all cases in the sample.”120 Professor Lipson concluded that despite statements by some commentators to the contrary, examiners “are neither ‘routinely’ sought nor ‘automatically’ appointed in large cases.”121 Professor Lipson also concluded that examiners were more likely appointed in “huge,” contentious cases, and that a request for the appointment of a trustee increases 016 the odds that an examiner will be appointed.122 21, 2 r mbe Nove on ived Setting aside the debt threshold in section 1104(c)(2), courts have generally interpreted the arch 5363 “interests” test in section 1104(c)(1) to obroadly encompass the interests of all parties in interest. 14-3 N . n, As one court explained, “thehbasicow of an examiner is to examine, not to act as a protagonist in . Br job et v ixs in Bl cited 117 For a general discussion of the role and appointment of examiners in chapter 11 cases, see Jonathan C. Lipson, Understanding Failure: Examiners and the Bankruptcy Reorganization of Large Public Companies, 84 Am. Bankr. L.J. 1 (2010). 118 11 U.S.C. § 1104(c). 119 See, e.g., In re Wash. Mutual, Inc., 442 B.R. 314, 324 (Bankr. D. Del. 2011) (“The Court denied the Initial Examiner Motion . . . finding that there was no appropriate scope for an examiner to conduct an investigation given that issues pertinent to, and even beyond the scope of, the chapter 11 cases had been ‘investigated to death.’”); In re Spansion, Inc., 426 B.R. 114, 127 (Bankr. D. Del. 2010) (“I find no sound purpose in appointing an examiner, only to significantly limit the examiner’s role when there exists insufficient basis for an investigation. To appoint an examiner with no meaningful duties strikes me as a wasteful exercise, a result that could not have been intended by Congress.”); In re Erickson Ret. Communities, LLC, 425 B.R. 309, 312 (Bankr. N.D. Tex. 2010) (“At first blush, the issue here seems to be whether, because the $5 million unsecured debt threshold is met . . . the appointment of an examiner is mandatory. Many courts have been confronted with this issue and have held yes — an examiner is required whenever the $5 million unsecured debt threshold of Section 1104(c)(2) is met. This court agrees with such courts that, where the $5 million unsecured debt threshold is met, a bankruptcy court ordinarily has no discretion. The only judicial discretion that comes into play is in defining the scope of the examiner’s role/duties. The court can make the scope of an examiner’s duties very broad or very narrow.” (citations omitted)); In re Vision Dev. Grp. of Broward Cnty., LLC, 2008 WL 2676827, at *3 (Bankr. S.D. Fla. Jun 30, 2008) (“[A] request for, and appointment cannot be waived by request made late in case of, an examiner may be made ‘at any time before the confirmation of the plan.’”) (quoting 11 U.S.C. § 1104(c)(2)). See also Walton v. Cornerstone Ministries Invs., Inc., 398 B.R. 77, 81 (N.D. Ga. 2008) (“[E]very district court and nearly every bankruptcy court that has confronted the question has also read the provision to be mandatory on its face.”); In re Schepps Food Stores, Inc., 148 B.R. 27, 30 (S.D. Tex. 1992) (“This reasoning is both grammatically and contextually wrong. In the provision, ‘as is appropriate’ modifies ‘investigation.’ The statute allows the court to determine the scope, length, and conduct of the investigation, rather than the appointment itself.”). 120 Jonathan C. Lipson, Understanding Failure: Examiners and the Reorganization of Large Public Companies, 84 Amer. Bankr. L. J. 1 (2010). See generally supra note 66 and accompanying text (generally discussing limitations of chapter 11 empirical studies). 121 Id. at 4. Indeed, Professor Lipson includes this quote from the Honorable Robert Gerber of the U.S. Bankruptcy Court for the Southern District of New York: “[M]andatory appointment [of examiners] is terrible bankruptcy policy, and the Code should be amended . . . to give bankruptcy judges . . . the discretion to determine when an examiner is necessary and appropriate. . . .” Id. 122 Id. at 5. Professor Lipson also notes that examiners are more likely to be sought in cases pending in Delaware or the Southern District of New York (where most of the “huge” cases are filed), and that allegations of fraud do not automatically result in either a request for, or order appointing, an examiner. Id. IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 40 of 402 Bankruptcy Institute the proceedings.”123 For this reason, “appointment under § 1104(c)(1) must, therefore, be in the interests of everyone with a stake in the case, including creditors, equity security holders, and other interests of the estate.”124 When only certain parties (i.e., the movants) would likely benefit from the appointment of an examiner, such request was not deemed to satisfy the “interests” test.125 In deciding whether to appoint an examiner, courts have also considered the overall financial benefit that an examiner could bring to the estate.126 Allegations of corporate fraud and misconduct by a debtor’s insiders or affiliates are often cited as reasons for appointing an examiner so that the examiner may investigate such allegations.127 It is noteworthy that although the language in section 1104 is not explicit, some courts and scholars have stated that the “interests” test for the appointment of examiners is the same “interests” test that is applied to the appointment of trustees: the “best interests” test.128 This reasoning may be based on the fact that the “interests” test in section 1104(a) respecting trustee appointments and section 1104(c) respecting examiner appointments is substantially identical;129 indeed, the statute does not explicitly provide for a “best interests” test.130 123 Official Comm. of Asbestos Pers. Injury Claimants v. Sealed Air Corp. (In re W.R. Grace & Co.), 285 B.R. 148, 156 (Bankr. D. Del. 2002). 124 In re Gliatech, Inc., 305 B.R. 832, 836 (Bankr. N.D. Ohio 2004) (citations omitted). Another court explained that “[a] single creditor group ‘cannot justify the appointment of a[n] . . . examiner simply by alleging that it would be in its interests.’” In re Sletteland, 260 B.R. 657, 672 (Bankr. S.D.N.Y. 2001) (citations omitted). See also In re Lenihan, 4 B.R. 209, 212 (Bankr. D.R.I. 1980) (“[W]ill such an appointment benefit the estate of the debtor and the interests of creditors? A bankruptcy court, which must eventually pass upon questions of fairness, good faith, best interest, etc. prior to confirmation, cannot blindfolded by the 016 tactical jockeying of the parties in determining what is in the interest of the estate.”) (citations omitted). 21, 2 berand remanded on other grounds, 125 See, e.g., In re Loral Space & Commc’ns Ltd., 313 B.R. 577, 583–84 (Bankr. S.D.N.Y. 2004),m d ove rev’ 2004 WL 2979785 (S.D.N.Y. Dec. 23, 2004) (“The Ad Hoc Committee’s motion clearly fails the ‘in the interests of the estate’ test on N edthe appointment of an examiner must be in the hiv of section 1104(c)(1) of the Bankruptcy Code. First, under section 1104(c)(1) 3 arc interests of the estate in general. Here, however, the appointment6of an examiner would, at best for the shareholders, advance -353 4 only their interests in opposition to the Debtors’ plan.”). . 1 appeal, the district court reversed and remanded to the bankruptcy , NoOn rown court, mandating the appointment of an examiner but solely on the ground that “[o]n its face, Section 1104(c)(2) mandates the v. B appointment of an examiner where seth in interest moves for an examiner and the debtor has $5,000,000 of qualifying debt.” a party Blix n Ltd., 2004 WL 2979785, at *4 (S.D.N.Y. Dec. 23, 2004). i In re Loral Space & Commc’ns cited 126 See, e.g., In re Loral Space & Commc’ns Ltd., 313 B.R. 577, 584 (Bankr. S.D.N.Y. 2004), rev’d and remanded on other grounds, 2004 WL 2979785 (S.D.N.Y. Dec. 23, 2004) (“[T]he appointment of an examiner would not be in the estates’ interest in the light of the negligible benefits of the requested valuation balanced against its cost.”); In re Shelter Res. Corp., 35 B.R. 304, 305 (Bankr. N.D. Ohio 1983) (“The appointment of an examiner would entail undue delay in the administration of this estate and most likely cause the debtor to incur substantial and unnecessary costs and expenses detrimental to the interests of creditors and parties in interest.”); In re Hamiel & Sons, Inc., 20 B.R. 830, 837 (Bankr. S.D. Ohio 1982) (conducting cost/benefit analysis when considering appointment of trustee or examiner). 127 See, e.g., In re Keene Corp., 164 B.R. 844, 856 (Bankr. S.D.N.Y. 1994) (“Often, appointment of an examiner is warranted when the debtor’s transactions with affiliates should be investigated.”) (quoting M. Bienenstock, Bankruptcy Reorganization 299 (1987)). Another bankruptcy court appointed an examiner because it found that it was in the interest of creditors to involve an examiner in light of the significant amount of debt, receivables, and other obligations at stake and that “[t]he involvement of an examiner will contribute valuable perspective to a case with many competing interests at stake.” In re First Am. Health Care of Ga., Inc., 208 B.R. 992, 995 (Bankr. S.D. Ga. 1996). 128 See In re Lenihan, 4 B.R. 209, 211 (Bankr. D.R.I. 1980) (holding that the decision to appoint an examiner “rests on a determination by the court that such appointment would be in the best interests of creditors, equity security holders, and the estate; the same test used to determine whether the appointment of a trustee is warranted”) (emphasis added); Ryan M. Murphy, Does the Recent String of Examiner Appointments in Delaware Represent a Sea Change in Approach or Merely a Perfect Storm of Cases?, Norton J. Bankr. L. 2011.04-2 (2011) (“[A] bankruptcy court is authorized to appoint an examiner under two scenarios: (1) where it is in the best interest of the estate and interested parties; or (2) where the debtor’s fixed, unliquidated debts (excluding claims for goods, services, taxes and insider transactions) exceed $5 million.”) (citations omitted) (emphasis added); 5 Norton Bankr. L. & Prac. 3d § 99:25 (“The ‘best interests’ test for the appointment of an examiner, like the Code § 1104(a)(2) provision for the appointment of a trustee6 is a flexible and discretionary standard.”). 129 Section 1104(a) provides that the court shall appoint a trustee if, among other reasons, “such appointment is in the interests of creditors, any equity security holders, and other interests of the estate.” 11 U.S.C. § 1104(a)(2). Section 1104(c) provides that the court shall appoint an examiner if, setting the debt threshold aside, “such appointment is in the interests of creditors, any equity security holders, and other interests of the estate.” 11 U.S.C. § 1104(c)(1). 130 “Sections 1104(a)(2) and (c)(1) of the Bankruptcy Code, using identical language, authorize the appointment of a trustee or examiner, respectively, if ‘such appointment is in the interests of creditors, any equity security holders, and other interests of the estate.’ Under these provisions, a creditor group, no matter how dominant, cannot justify the appointment of a trustee or examiner simply by alleging that it would be in its interests. It must show that the appointment is in the interests of all those with a stake in the estate, which in this case would include the Debtor. As Collier points out, ‘Use of the word ‘and’ suggests that creditors cannot on their own obtain the appointment of a trustee under the provision in order to disenfranchise equity security holders or other interests.’” In re Sletteland, 260 B.R. 657, 672 (Bankr. S.D.N.Y. 2001).  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 41 of Chapter  If appointed, the primary duty of an examiner under current law is to (i) “conduct such an investigation of the debtor as is appropriate, including an investigation of any allegations of fraud, dishonesty, incompetence, misconduct, mismanagement, or irregularity in the management of the affairs of the debtor of or by current or former management of the debtor”131 and (ii) “(A) file a statement of any investigation conducted . . . including any fact ascertained pertaining to fraud, dishonesty, incompetence, misconduct, mismanagement, or irregularity in the management of the affairs of the debtor, or to a cause of action available to the estate; and (B) transmit a copy or a summary of any such statement to any unsecured creditors’ committee or equity security holders’ committee, to any indenture trustee, and to such other entity as the court designates.”132 The examiner’s investigation and report may have an important effect on the direction of the case, as well as on the pursuit of claims for the benefit of creditors. For example, the examiner’s reports in the chapter 11 cases of Lehman Brothers, Residential Capital, and Tribune Company assessed the merits of claims asserted by parties in the case, identified additional potential claims and causes of action, and provided parties in interest with substantial information concerning the debtor and its case that otherwise likely would have been undiscovered or unavailable.133 Commentators summarize these benefits as follows: If equipped with a mandate of sufficiently broad scope, an examiner may promote efficiency by navigating among the frequent multiplicity of other investigations by government authorities, boards of directors, creditors, and shareholders.6 examiner The 201 r 21,by conducting an may play the lead role among the players in the bankruptcybe case ovem on N later in pursuing monetary expansive and timely investigation that will aidved i parties arch 363 recoveries and other remedies. In many respects, the examiner should preempt the -35 o. 14 bankruptcy field by vastlyown, N reducing the need for early and duplicative discovery v. Br efforts by separate seth lix creditors or committees. 134 in B cited Notwithstanding the potential benefit to the estate, some observers argue that an examiner simply adds another layer of cost and delay to the process and that the debtor in possession or unsecured creditors’ committee can serve the same function.135 The primary response to this potential critique is that an examiner comes to the process with a special, independent, and neutral role, which no other party can claim. The principle that the proper role of an examiner is that of a disinterested, nonadversarial officer of the court has been so widely accepted that it can hardly be doubted.136 131 11 U.S.C. § 1104(c). 132 Id. § 1106(a)(4) (referred to in 11 U.S.C. § 1106(b)). 133 See Report of Kenneth N. Klee, Examiner, In re Tribune Co., No. 08-13141 (July 26, 2010) [Docket Nos. 5130, 5131, 5132, 5133]; Report of Anton R. Valukas, Examiner, In re Lehman Bros. Holdings, Inc., No 08-13555 (Bankr. S.D.N.Y. Mar. 11, 2010) [Docket No. 7531]; Report of Arthur J. Gonzalez, Examiner, In re Residential Capital, LLC, No. 12-12020 (Bankr. S.D.N.Y. May 13, 2013) [Docket No. 3698]. (Kenneth N. Klee and Arthur J. Gonzalez are Commissioners.) 134 Clifford J. White III & Walter W. Theus, Jr., Chapter 11 Trustees and Examiners after BAPCPA, 80 Am. Bankr. L. J. 289, 290 (2006). 135 See, e.g., Dickerson, supra note 19, at 904 (“[H]aving an examiner in a case can substantially increase the costs of the reorganization and, accordingly, reduce the amount available to pay creditor claims. Because examiners are often appointed in cases that have active creditor committees, courts have refused to appoint an examiner if doing so would increase the number of fiduciaries already involved in a case. Some courts have argued that examiners often duplicate the work already being performed by creditors’ committees.”). 136 Examples of cases stating this principle: Kovalesky v. Carpenter, 1997 WL 630144, at *3 (S.D.N.Y. Oct. 9, 1997) (“Examiners . . . play a chiefly information-seeking role and, like the court itself, must remain a neutral party in the bankruptcy process.”); In re Big Rivers Elec. Corp., 213 B.R. 962, 977 (Bankr. W.D. Ky. 1997) (“[The examiner is] a party who is not an adversary but rather an independent third party and officer of the Court.”); In re Interco Inc., 127 B.R. 633, 638 (Bankr. E.D. Mo. 1991) (“[T] he Examiner’s role is by its nature disinterested and nonadversarial. There is no doubt that the Examiner is a neutral party in a bankruptcy case.”); In re Baldwin United Corp., 46 B.R. 314, 316 (Bankr. S.D. Ohio 1985) ([The Examiner] is first and foremost disinterested and nonadversarial. . . . [H]e answers solely to the Court.”). IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 42 of 402 Bankruptcy Institute Accordingly, the examiner provides an independent assessment of the matter at hand and can identify value, encourage parties to recognize the strengths and weaknesses of their respective positions in the case, facilitate quicker resolutions of disputes, and ultimately produce benefits for the estate. Nevertheless, one criticism of the process is that the examiner’s report, which may identify this value and was paid for by the estate, may not be admissible as evidence in prosecuting or defending the causes of action investigated in the report. Under current law, the role of an examiner is limited to the investigatory function described above. Yet examiners may add value to cases in other capacities given their uniquely independent and neutral posture. For example, courts have appointed mediators and facilitators to help chapter 11 cases progress, either when plan negotiations are stalled or major litigation threatens to derail reorganization efforts.137 Such mediators and facilitators have proven effective in some cases, but they currently are appointed on an ad hoc basis and with little governing authority. Expanding the potential scope of an examiner to include the role of mediator and facilitator as well as similar functions would allow parties in interest and the court to use an independent neutral party to address specific issues in a particular case in an efficient and controlled manner. Many courts interpret section 1104 as currently prohibiting this kind of appointment, whether termed an “examiner” with expanded powers or a “trustee” with limited powers.138 The Estate Neutral: Recommendations and Findings 16 1, 20 ber 2 em n concerning the frequency and The Commission reviewed the case law and academic literatureNov ed o hiv use of examiner appointments and the interpretation rc the current statute, which mandates 63 a of -353 . 14 the appointment of an examiner in certain ocircumstances. The Commissioners explored, in the ,N rown B h v. alternative, the utility of a newsestate neutral, particularly in cases when, for example, stakeholders x et n Bli i c ed found value in leavingitthe debtor in possession in control, but certain matters in the case needed an independent assessment either because it was difficult for a debtor to investigate itself or because the debtor and stakeholders were too vested in their respective positions to identify areas of potential 137 Examples of cases using court-appointed mediators: In re R.H. Macy & Co., Inc. 1994 WL 482948 (Bankr. S.D.N.Y. Feb. 23, 1994); In re Lehman Bros., Inc., Ch. 11 Case No. 08-13555 (JMP) (Bankr. S.D.NY.) (Jan. 16, 2009) [Docket No. 2569]. See also Cassandra G. Mott, Macy’s Miracle on 34th Street: Employing Mediation to Develop the Reorganization Plan in a Mega-Chapter 11 Case, 14 Ohio St. J. on Disp. Resol. 193, 207–10 (1998); Harvey R. Miller, The Changing Face of Chapter 11: A Reemergence of the Bankruptcy Judge as Producer, Director, and Sometimes Star of the Reorganization Passion Play, 69 Am. Bankr. L.J. 431, 437 (1995). For an example of a court-approved arbitration procedure in the context of claims resolutions, see Meyer v. Dalkon Shield Claimants Trust, 164 F.3d 623, at *1 (4th Cir. 1998) (unpublished table decision) (explaining alternative dispute resolution procedures used to address products liability claims). 138 See, e.g., Official Comm. of Asbestos Pers. Injury Claimants v. Sealed Air Corp. (In re W.R. Grace & Co.), 285 B.R. 148, 156–57 (Bankr. D. Del. 2002) (denying debtor’s motion to appoint examiner with expanded powers or trustee with limited purpose to prosecute fraudulent transfer claims because “the basic job of an examiner is to examine, not to act as a protagonist in the proceedings” and “[t]here is no such entity as a limited purpose trustee under the [Bankruptcy] Code”); Kovalesky v. Carpenter, 1997 WL 630144, at *3 (S.D.N.Y. Oct. 9, 1997) (“Examiners . . . play a chiefly information-seeking role and, like the court itself, must remain a neutral party in the bankruptcy process.”); In re Interco Inc., 127 B.R. 633, 638 (Bankr. E.D. Mo. 1991) (“[T]he examiner’s role is by its nature disinterested and non-adversarial. There is no doubt that the examiner is a neutral party in a bankruptcy case.”); In re Baldwin United Corp., 46 B.R. 314, 316–17 (Bankr. S.D. Ohio 1985) (“[W]e never contemplated, nor in our opinion does the Bankruptcy Code contemplate, that the examiner act as a conduit of information to fuel the litigation fires of third-party litigants.”); In re Hamiel & Sons Inc., 20 B.R. 830, 832 (Bankr. S.D. Ohio 1982) (an examiner “constitutes a court fiduciary and is amenable to no other purpose or interested party”). But see S. Rep. No. 989, 95th Cong. 2d Sess. 116 (1978), reprinted in 1978 U.S.C.C.A.N. 5787 (“The [bankruptcy] court is authorized to give the examiner additional duties as circumstances warrant.”); In re Mirant Corp., 2004 WL 2983945, at *2–3 (Bankr. N.D. Sept. 1, 2004) (examiner authorized to monitor and mediate plan negotiations); In re Pub. Serv. Co. of N.H., 99 B.R. 177 (Bankr. D.N.H. 1989) (examiner authorized to mediate negotiations related to chapter 11 plan); In re UNR Indus., Inc., 72 B.R. 789 (Bankr. N.D. Ill. 1987) (examiner appointed to negotiate chapter 11 plan and facilitate resolution of substantive differences).  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 43 of Chapter  compromise. As further explained below, the Commission determined that the concept of an estate neutral should replace examiners under the Bankruptcy Code. The Commissioners found little correlation between the standards for a mandatory appointment and the utility of the appointee in any given case, based on experiences with examiners under section 1104(c) of the Bankruptcy Code. Accordingly, the Commission voted to eliminate the mandatory nature of the appointment process and to permit the court to order the appointment of an estate neutral, upon request of a party in interest or the U.S. Trustee and after notice and a hearing, if such appointment would be in the best interests of the estate. The Commission specifically considered the existing case law, and it rejected a standard that required all interests to be served by the appointment. It found that, given the role contemplated for estate neutrals under these principles, the appointment standard should be flexible and tailored by the court to the particular case. Courts should determine if, on balance, the best interests of the estate would be served by the appointment. The Commissioners further discussed the proper role of estate neutrals in the reorganization process. Absent the appointment of a trustee, all parties in the chapter 11 case have potentially diverging interests and may be motivated purely by self-interest. For example, the debtor in possession acts as a fiduciary for the estate, but the estate itself likely has different constituencies. The debtor in possession is also working to reorganize its business and preserve relationships with employees, vendors, and other constituents that ultimately serve the interests of the estate. Likewise, a statutory 6 unsecured creditors’ committee owes its duties to general unsecureder 21, 201 but those creditors creditors, b are not the only stakeholders in the case. The Commissioners ovem N observed that an estate neutral-like d on chive independent and neutral perspective in appointee is the only party uniquely situated to3provide an 3 ar 35 6 . 14the case. The Commission also considered other potential rationales for expanding the role of the , No own . traditional examiner in chapter 11 cases, such as facilitating dispute va Br new estate neutral from thattof eh Blixs resolution and reducing information asymmetries. ed in cit The Commissioners recognized the costs associated with the appointment of an examiner under the current law, as well as the additional costs that might accompany the new estate neutral, which could be used more frequently and for a wider array of tasks. Not only would the estate compensate the estate neutral, but the estate also would compensate any professionals that the court authorizes the estate neutral to retain. The Commissioners explored ways to contain these costs, including through court-approved budgets and restrictions on the efforts by the debtor in possession and the unsecured creditors’ committee that may be duplicative of those assigned to the estate neutral. The Commissioners believed that this kind of oversight by the court and other stakeholders could mitigate the potential increases in costs. The Commissioners did not believe, however, that such restrictions should be statutorily mandated, but rather left to the court and parties in interest to determine in any given case. The Commission also considered the potential cost savings that an estate neutral may generate in cases when the parties are at an impasse in negotiations or need an independent investigation to facilitate resolution of particular matters. The Commissioners discussed how courts should balance the costs associated with an estate neutral with the potential efficiencies created by the appointment. The Commissioners also observed that, even under this cost-benefit analysis, the circumstances of the case could warrant the appointment of more than one estate neutral to perform different functions IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 44 of 402 Bankruptcy Institute in the case, but the Commissioners believed that this should be the exception rather than the rule. The Commissioners did not want to create roles for third parties in the case or impose additional costs on the process if unnecessary or if the benefits would be marginal at best. Accordingly, the Commission recommended a presumption against the appointment of more than one estate neutral in any given case, which could be rebutted by evidence that the circumstances of the case and a costbenefit analysis support the additional appointment. The Commission also concluded that, with the elimination of the mandatory appointment provision, if the circumstances of the case warrant the appointment of an estate neutral, the potential benefit of the estate neutral to the estate would likely outweigh any additional costs to the estate. The Commission ultimately voted to provide more flexibility to the court and the parties in using estate neutrals, as set forth in the principles above, and to recommend use of estate neutrals in lieu of examiners. The Commissioners discussed the related concept of a statutory reorganization executive, which would be similar in some ways to an examiner with expanded powers but different in several key respects. For example, a statutory reorganization executive would likely be suggested and supported by the debtor and could operate the debtor’s business, work directly with the parties to help facilitate a plan, and function more as an insider of the debtor (akin to a chief restructuring officer).139 The Commissioners explored the contours of this new fiduciary, which some Commissioners believed would need to be accountable to the debtor’s board of directors and subject to applicable state fiduciary duty laws. The Commissioners who supported the concept of a statutory reorganization 16 executive viewed it as a private solution that parties would use moreber 21, 20 than seeking the readily vem appointment of a trustee or examiner. The Commissioners whooopposed the concept of a statutory n No ed r iv reorganization executive voiced concerns similar to5those ch 63 a noted above respecting an examiner with -3 3 . 4 expanded powers and viewed the appointment1of a trustee as the better alternative. Ultimately, the , No rown Commission voted against the seth v. B of a statutorily recognized reorganization executive, but did concept Blix ed in of such a position in considering and developing the parameters of the consider the potentialitvalue c role of an estate neutral. 4. Statutory Committees Recommended Principles: Except as provided in the principles for small and medium-sized enterprise cases, the appointment of an unsecured creditors’ committee should remain mandatory as provided under section 1102(a) of the Bankruptcy Code unless the court orders otherwise for cause. The term “cause” should include that such an appointment would not be in the best interests of the estate or that the interests of general unsecured creditors do not need representation in the particular case because, for 139 The Commissioners distinguished a chief restructuring officer from the proposed statutory reorganization executive, as the chief restructuring officer typically is retained as an officer of the company under applicable state law, subject to the same duties and obligations as the debtor’s other officers. The Commissioners found the current process for engaging chief restructuring officers in appropriate cases sufficient and not inconsistent with the Commission’s position on either the estate neutral or the restructuring officer.  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 45 of Chapter  example, they will not receive any distributions in the case or their claims will be paid in full. The court sua sponte, the U.S. Trustee, or a party in interest should be able to initiate a hearing to determine whether the appointment or continuation of an unsecured creditors’ committee would be in the best interests of the estate. The U.S. Trustee should continue to retain discretion to appoint a committee of equity security holders, more than one committee of unsecured creditors, or a single statutory committee for multiple affiliated debtors. Accordingly, no change to existing law is suggested on this point. Statutory Committees: Background The concept of a committee of creditors formed to monitor the debtor and its reorganization efforts stems from the equity receiverships of the late 1800s and Chapter XI of the Bankruptcy Act.140 The unsecured creditors’ committees that were formed in the equity receivership context were criticized for their close and arguably collusive relationships with the debtor.141 Nevertheless, Congress recognized the value in the committee structure, both in terms of their oversight functions and the 142 dynamic tension that their presence and participation adds to restructuring 2016 1, negotiations. Congress ber 2 thus maintained some form of committees in the Bankruptcy Noveand extended that structure to all Act m n ed o Code. hiv business reorganizations under chapter 11 of the Bankruptcy 3 arc 536 14-3 No. n, of the Bankruptcyrow . B Code provides that “the United States trustee shall appoint a eth v ixs creditorsBholding unsecured claims”143 that “shall ordinarily consist of the persons, in l cited Section 1102 committee of willing to serve, that hold the seven largest claims against the debtor of the kinds represented on such committee. . . .”144 The legislative history of section 1102 suggests that Congress intended to give unsecured creditors a stronger voice in the reorganization process.145 The unsecured creditors’ 140 In an equity receivership, “creditors would petition the court for the receivership and form a protective or reorganization committee. In most cases, the reorganization committee, working with management, would be the successful bidder at the receivership sale.” Michelle M. Harner & Jamie Marincic, Committee Capture? An Empirical Analysis of the Role of Creditors’ Committees in Business Reorganizations, 64 Vand. L. Rev. 749, 758–760 nn. 46–59 (2011) (explaining history of creditors’ committees in bankruptcy and providing citations to additional resources). “Chapter XI charges creditors’ committees with overseeing the conduct of the debtor and negotiating the debtor’s plan of reorganization; for the most part, they were active participants in cases.” Id. at 760. 141 Justice Douglas observed: “In the welter of conflicting interests, ulterior objectives, and self-serving actions which flow from investment banker-management dominance over committees, these committees have lost sight of their essential functions which they can perform to advance the interests of investors.” To Amend the Securities Act of 1933: Hearing on H.R. 6968 Before the H. Interstate and Foreign Commerce Comm’n., 75th Cong. 24 (1937) (statement of William O. Douglas). 142 “The mandatory appointment of a creditors’ committee was intended to provide dynamic tension with the debtor that would stimulate the reorganization process through effective and efficient oversight and negotiation.” Miller, supra note 41, at 449. See also Michelle M. Harner & Jamie Marincic, The Potential Value of Dynamic Tension in Restructuring Negotiations, Am. Bankr. Inst. J., Feb. 2011, at 62–65; Thomas C. Given & Linda J. Philipps, Equality in the Eye of the Beholder — Classification of Claims and Interests in Chapter 11 Reorganizations, 43 Ohio St. L. J. 735, 735–36 (1982) (explaining “dynamic tension” in context of reorganization vs. liquidation restructuring options); Donald R. Korobkin, Bankruptcy Law, Ritual and Performance, 103 Colum. L. Rev. 2124, 2130 (2003) (explaining that results under bankruptcy laws often “spontaneously emerge . . . at a juncture of futility and loss, from the dynamic and generative tension of normative directives in unavoidable conflict”). 143 11 U.S.C. § 1102(a)(1). 144 Id. § 1102(b)(1). 145 “This section [1102] provides for the appointment of creditors’ and equity security holders’ committees, which will be the primary negotiating bodies for the formulation of the plan of reorganization. They will represent the various classes of creditors and equity security holders from which they are selected. They will also provide supervision of the debtor in possession and of the trustee, and will protect their constituents’ interests.” H.R. Rep. No. 95–595, at 401 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6357. IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 46 of 402 Bankruptcy Institute committee has been viewed not only as necessary to protect the interests of the many unsecured creditors unable to participate directly in the process, but also to further monitor the actions of the debtor in possession during the chapter 11 case. It can play “many roles” in a chapter 11 case.146 The appointment of a committee of unsecured creditors is mandatory in chapter 11 cases, but cases do proceed without committees in certain circumstances. For example, the U.S. Trustee can only constitute a committee if a sufficient number of creditors are willing to serve on the committee.147 An individual creditor will often engage in a cost-benefit analysis to decide whether to serve on the unsecured creditors’ committee. As a committee member, a creditor owes certain fiduciary duties, and its service consumes time and effort that could otherwise be devoted to the creditor’s own business. Consequently, unsecured creditors may decide, particularly in smaller chapter 11 cases, that the economics do not favor service on a committee of unsecured creditors. The U.S. Trustee must form (or try to form) a committee “as soon as practicable after the order for relief.”148 To meet this requirement, the U.S. Trustee, shortly after the petition date, actively solicits interest in committee service from the debtor’s unsecured creditor body. “The size and exigencies of a case guide the solicitation and formation process.”149 The U.S. Trustee typically solicits the debtor’s 20 largest unsecured creditors, but may expand its search to the top  30 if warranted by the case. Although many committee formation meetings are held in person, the U.S. Trustee also constitutes committees through telephone interviews, particularly in smaller cases.150 “What does 16 not vary, however, is the U.S. Trustee’s need to gauge a creditor’s genuine willingness to serve on the 1, 20 ber 2 vem committee for legitimate reasons and the committee members’ obligation to act as fiduciaries to the n No ed o iv arch entire unsecured creditor constituency.”151 363 -35 o. 14 n, N ow The U.S. Trustee generally triesthto. appoint members to the committee who reflect the general v Br lixse B unsecured claims pooled inthe particular case — e.g., bonds, trade, landlords, etc.152 Section  1102 cit in allows parties in interest to request, and the court to direct, a change in the composition of the unsecured creditors’ committee or the appointment of additional committees.153 The U.S. Trustee is the party, however, that implements the change in the composition of the unsecured creditors’ committee or constitutes any additional committees. Moreover, section 1102 does not specifically address whether a single unsecured creditors’ committee may represent the interests of unsecured creditors in multiple, jointly administered cases. The U.S. Trustee has used a single unsecured 146 In re Haskell-Dawes, Inc., 188 B.R. 515, 521 (Bankr. E.D. Pa. 1995). “[T]he Bankruptcy Code authorizes such committees to, inter alia: consult with the trustee concerning the administration of the case; investigate the acts, conduct and financial condition of the debtor; investigate the operation of the debtor’s business and the desirability of having such business continue; participate in the formulation of a plan; and provide advice to those whom the committee represents regarding any plan that is formulated.” Id. at 519. 147 Roberta A. DeAngelis & Nan Roberts Eitel, Committee Formation and Reformation: Considerations and Best Practices, Am. Bankr. Inst. J., Oct. 2011, at 20 n. 2 (noting that the U.S. Trustee “often cannot appoint a committee in other cases because an insufficient number of creditors are willing to serve”). See Harner & Marincic, Committee Capture?, supra note 140, at 777 (finding that in a study of chapter 11 cases filed between 2002 and 2008, 48.3 percent of cases involved at least one creditors’ committee and 51.7 percent involved no creditors’ committee). See also In re Aspen Limousine Serv., Inc., 187 B.R. 989, 994 n.6 (Bankr. D. Colo. 1995), aff ’d as modified, 198 B.R. 341 (D. Colo. 1996) (“[I]n practice, a committee is rarely appointed in a smaller case.”); In re ABC Auto. Prods. Corp., 210 B.R. 437, 442–43 (Bankr. E.D. Pa. 1997) (“[A]s courts and commentators alike have noted, in many cases creditors’ committees are inactive or ineffectual.”). 148 11 U.S.C. § 1102(a)(1). 149 DeAngelis & Eitel, supra note 147, at 20. 150 Id. 151 Id. 152 In re Park W. Circle Realty, LLC, 2010 WL 3219531, at *2 n. 6 (Bankr. S.D.N.Y. Aug. 11, 2010) (“Although committees do not necessarily need to reflect the precise composition of the creditor body, committees should adequately represent the various creditor types.”); accord In re Hills Stores Co., 137 B.R. 4, 7 (Bankr. S.D.N.Y. 1992). 153 11 U.S.C. § 1102(a)(2), (4).  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 47 of Chapter  creditors’ committee in such cases under certain circumstances, and courts have generally approved this approach.154 Once appointed, the unsecured creditors’ committee serves in a fiduciary capacity with respect to the other unsecured creditors it represents and is granted certain powers under section 1103 of the Bankruptcy Code.155 The committee may, among other things, meet with the debtor, investigate the debtor’s affairs, participate in the plan formulation process, and request the appointment of a trustee or examiner.156 The committee may also retain professionals to represent it in the chapter 11 case.157 The expenses of committee members and the fees and expenses of the committee’s counsel and other professionals are generally paid from the estate. Statutory Committees: Recommendations and Findings The Commissioners had a robust discussion regarding the ongoing utility of unsecured creditors’ committees in chapter 11 cases. Some Commissioners felt that the mandatory nature of a committee of unsecured creditors was no longer warranted given that the fulcrum claims are now secured claims in many debtors’ capital structures. Thus, a committee may not be needed because (i) unsecured creditors anticipate being paid in full or (ii) the creditors it represents may be out of the money in many cases. These Commissioners proposed treating the appointment of all statutory committees as discretionary, the way in which the current law treats the appointment of equity security holders’ 16 1, 20 committees.158 ber 2 vem n No ed o iv Other Commissioners believed that the oversight rch 63 a function served by the unsecured creditors’ -353 . 14 committee is critical to the process and should be preserved. The Commissioners noted the valuation , No rown challenge of determiningxseth v.in a chapter 11 case that classes of debt are in the money or out of early B n Bli the money. For cited ireason alone, a per se rule based on the value of unsecured claims would be this inadequate. The Commissioners also highlighted the role of the unsecured creditors’ committee in creating value or critically analyzing the debtor’s proposed reorganization plan to ensure that the enterprise value would not be artificially depressed or removed from the estate. 154 See, e.g., In re Orfa Corp. of Phila., 121 B.R. 294, 299 (Bankr. E.D. Pa. 1990) (rejecting a per se rule regarding the appointment of a committee for each related debtor due to “the additional and unnecessary administrative costs that would result if another committee and a potential enclave of additional professionals [are] appointed”); In re McLean Indus, Inc., 70 B.R. 852, 862 (Bankr. S.D.N.Y. 1987) (noting the cost of separate committees “could be extreme”). But see In re White Motor Credit Corp., 18 B.R. 720, 722 (Bankr. N.D. Ohio 1980) (“As a matter of law, section 1102 indicates that each case should have a Court-appointed committee. While such language does not preclude the Court from appointing identical committees in related cases, it cannot be said to authorize a single committee under the circumstances of these proceedings.”); In re Proof of the Pudding, Inc., 3 B.R. 645, 649 (Bankr. S.D.N.Y. 1980) (noting that “completely independent committees, devoid of overlapping membership, can better serve the interests of all of the other creditors in closely related cases”). 155 See, e.g., In re Fas Mart Convenience Stores, Inc., 265 B.R. 427, 432 (Bankr. E.D. Va. 2001) (“Members of the committee also have another duty — a fiduciary duty to all creditors represented by the committee.”); In re Firstplus Fin., Inc., 254 B.R. 888, 894 (Bankr. N.D. Tex. 2000) (“In a Chapter 11 case, an Unsecured Creditors’ Committee is appointed by the Office of the United States Trustee and owes a fiduciary duty to act on behalf of all unsecured creditors.”). 156 11 U.S.C. § 1103(c). 157 Id. § 1103(a). 158 See, e.g., Written Statement of Daniel Kamensky on behalf of Managed Funds Association: LSTA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (Oct. 17, 2012) (“In such cases, the statutory creditors’ committee is not an equal negotiating partner of the debtor, since it represents creditors with a de minimis stake in the future company. In fact, the only avenue of recovery for unsecured creditors in such cases is typically litigation of sometimes dubious causes of action, which can cause the statutory committee to focus unduly on future litigation value. It therefore may not be appropriate for a statutory creditors’ committee to be appointed in these cases; or, at least, limits should be placed on the committee’s role.”) (citations omitted). IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 48 of 402 Bankruptcy Institute After extensive deliberation, the Commission recommended retaining the mandatory appointment of a committee of unsecured creditors in all cases, except small and medium-sized enterprise cases (addressed in a subsequent section).159 The Commissioners found value in the traditional “watchdog” function of the committee, not only as a check on the debtor in possession, but also as a check on other stakeholders and the allocation of the estate’s value among stakeholders. Indeed, unlike secured or administrative creditors — whose claims must be paid in order to confirm a plan — the Bankruptcy Code does not mandate any minimum return for general unsecured creditors (other than that they receive more than they would in a chapter 7 liquidation). The unsecured creditors’ committee is the primary statutory protection for general unsecured creditors. Nevertheless, the Commission did find merit in the argument that a committee should not be appointed if its constituents have no need for representation in the case (i.e., their claims are out of the money or are being paid in full). The Commission agreed that this standard should be part of a “for cause” standard that would, if established by evidence at the hearing, allow the court to direct the U.S. Trustee not to appoint, or to disband, an unsecured creditors’ committee. The Commission agreed that the potential benefits of an active committee of unsecured creditors must be carefully balanced against the costs and potential delays associated with the various actions that such a committee could be entitled to take. For example, the Commissioners discussed the kinds of cases in which tactics by a committee can increase costs or delay the resolution of a case or a material transaction in the case. Although many of the Commissioners acknowledged the infrequency of such 16 1, 20 instances, they also recognized the potential harm to the estate and its constituents when they do ber 2 vem occur. The Commission agreed, however, that the court and thedU.S. Trustee have sufficient authority n No e o r hiv under the law to monitor the activity of unsecured creditors’ccommittees and to implement appropriate 63 a -353 . 14 protections as needed. On that point, the Commissioners also discussed cases in which a committee , No rown of unsecured creditors was ordered v. Bshare professionals with other committees (or even the debtor, eth to Blixs ed in it provided appropriatecprotections were put in place) or in which a committee’s professionals’ fees and expenses were capped either overall or with respect to certain matters.160 Finally, the Commission considered the impact of potential conflicts of interests associated with the diverse membership of a typical committee of unsecured creditors. Specifically, the interests of one committee member may not align with those of other members or even with those of general unsecured creditors in a particular chapter 11 case.161 For example, the interests of an unsecured creditor seeking to acquire equity in the reorganized debtor in exchange for its claims may not align with the interests of the debtor’s trade creditors.162 Also, committee members who hold equity 159 See Section VII, Proposed Recommendations: Small and Medium-Sized Enterprise (SME) Cases. 160 For a discussion of the costs and potential complications associated with multiple committees, see Kenneth N. Klee & K. John Shaffer, Creditors’ Committees Under Chapter 11 of the Bankruptcy Code, 44 S.C. L. Rev. 995, 1024–25 (1993) (“[M]ultiple committees can complicate negotiations, delay the reorganization process, and create additional administrative expenses to the debtor’s estate, particularly in terms of higher professional fees.”). 161 See, e.g., Michael P. Richman & Jonathan E. Aberman, Creditors’ Committees Under the Microscope: Recent Developments Highlight Hazards of Self-Dealing, Am. Bankr. Inst. J., Sept. 2007, at 22 (examining chapter 11 cases involving committee member conflicts of interest); Burke Gappmayer, Protecting the Insolvent: How a Creditor’s Committee Can Prevent Its Constituents from Misusing a Debtor’s Nonpublic Information and Preserve Chapter 11 Reorganizations, 2006 Utah L. Rev. 439, 445–46 (discussing conflicts of interest that may affect creditors’ committee members); Carl A. Eklund & Lynn W. Roberts, The Problem with Creditors’ Committees in Chapter 11: How to Manage the Inherent Conflicts Without Loss of Function, 5 Am. Bankr. Inst. L. Rev. 129, 130–33 (1997) (analyzing problems posed by committee member conflicts); Nancy B. Rapoport, Turning and Turning in the Widening Gyre: The Problem of Potential Conflicts of Interest in Bankruptcy, 26 Conn. L. Rev. 913, 916–17 (1994) (examining conflict of interest issues in bankruptcy, including in committee context). 162 For example, section 1122(b) of the Bankruptcy Code permits a debtor use an administrative convenience class to pay trade creditors in full even when the plan is not able to fully repay claims of other unsecured creditors that will be discharged. See Brad B. Erens & Timothy W. Hoffmann, The Triumph of the Trade Creditor in Chapter 11 Reorganizations, J. Bankr. L., Jan. 2013, at  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 49 of Chapter  in a competitor of the debtor may have adverse interests. The Commissioners acknowledged that the U.S. Trustee was asking more nuanced questions concerning a creditor’s interests in a debtor’s case during the committee formation process.163 They recognized, however, that some conflicts of interest are inevitable. The Commission concluded that the court and the U.S. Trustee are both well positioned to address any problematic conflicts of interest that may arise on a committee on a caseby-case basis, in the same way in which they are empowered to address unnecessary costs and delays associated with unsecured creditors’ committees. 5. Estate Fiduciaries Recommended Principles: The doctrine set forth in Barton v. Barbour, 104 U.S. 126, 127–29 (1881) (which provides that to sue a court-appointed receiver, a party must obtain leave from the court that ordered such appointment) should also apply to the following parties in chapter 11 cases: trustees, estate neutrals, and statutory committees and their members, as well as professionals retained to represent any of the foregoing parties in their fiduciary capacity. 16 1, 20 ber 2 vem Estate Fiduciaries: Background n No ed o rchiv 6 a In Barton v. Barbour, the U.S. Supreme 1Court 3confirmed the “general rule that before suit is -353 o. 4 brought against a receiver leave Brown, N of the court by which he was appointed must be obtained.”164 The h v. Supreme Court alsoinheldset Blix that this general rule applies equally to suits seeking equitable relief cited 165 (e.g., to recover specific property) and damages (i.e., money). Courts have generally extended the Barton doctrine to trustees166 in bankruptcy and other officers appointed by the court. “As the Sixth Circuit has observed, under the Barton doctrine, ‘court appointed officers who represent the estate are the functional equivalent of a trustee.’”167 Accordingly, some courts have determined that postconfirmation trustees and members of the unsecured creditors’ committee are also deemed officers appointed by the court and thus covered by the Barton doctrine.168 163 164 165 166 167 168 26 (“[D]ebtors sometimes have promulgated plans with very large administrative convenience claim caps for trade claims. Any claim up to that cap would be paid in full. Even claims above such cap could voluntarily elect to reduce their claims to the cap and, to that extent, often receive close to full payment. In this manner, debtors have been able to pay trade creditors under a plan a higher percentage on account of their claims then, for instance, similarly situated unsecured bondholders.”). See, e.g., DeAngelis & Eitel, supra note 147, at 58–59 (explaining that the U.S. Trustee considers, among other things, whether “the creditor will be paid as a critical vendor, has an executory contract or lease that will be assumed (and defaults cured), holds claims among multiple levels of the company’s debt structure, or has insurance or other hedges that may limit its exposure or affect the identity of the true beneficial holder of the claim”). Barton v. Barbour, 104 U.S. 126, 128 (1881). “A suit . . . brought without leave to recover judgment against a receiver for a money demand, is virtually a suit the purpose of which is, and effect of which may be, to take the property of the trust from his hands and apply it to the payment of the plaintiff ’s claim, without regard to the rights of other creditors or the orders of the court which is administering the trust property.” Id. at 129. As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. In re Crown Vantage, Inc., 421 F.3d 963 (9th Cir. 2005) (quoting Allard v. Weitzman (In re DeLorean Motor Co.), 991 F.2d 1236 (6th Cir. 1993)). Id. See also Blixseth v. Brown, 470 B.R. 562 (D. Mont. 2012) (applying Barton doctrine to chair of the creditors’ committee). IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 50 of 402 Bankruptcy Institute The Barton doctrine is addressed, in part, by section 959(a) of title 28 of the U.S. Code, which provides that “[t]rustees, receivers or managers of any property, including debtors in possession, may be sued, without leave of the court appointing them, with respect to any of their acts or transactions in carrying on business connected with such property.”169 Courts have interpreted section 959(a) as an implicit limitation of the Barton doctrine and have acknowledged that litigation not covered by section 959(a) requires leave of court.170 A litigant is thus required to seek leave of the court with respect to litigation against a chapter 11 trustee or other officer appointed by the court in connection with the liquidation or administration of a debtor’s estate, except as provided in section 959(a). Moreover, some courts have extended the Barton doctrine to counsel for the trustee appointed by the court to the extent that such counsel was acting at the direction of the trustee for purposes of liquidating or administering the debtor’s estate.171 Estate Fiduciaries: Recommendations and Findings The Commissioners discussed the value of extending limited immunity to the chapter 11 trustee and similar fiduciaries for actions taken by them in their fiduciary capacity. In this context, the Commission reviewed the parameters of the Barton doctrine and its underlying policy justifications. The Commission agreed that the Barton doctrine should be codified to clarify its scope and application to any trustee, estate neutral, and statutory committee and its members 6 appointed in the 20 ,for 1 chapter 11 case. The Commissioners found value in the following justification such extension of r 21 mbe Nove n the Barton doctrine: ed o iv arch 5363 Just like an equity receiver, a trustee in. bankruptcy is working in effect for the court 14-3 No that appointed or approved .him, n, Brow administering property that has come under the th v lixseof the Bankruptcy Code. If he is burdened with having to court’s control by in B virtue cited defend against suits by litigants disappointed by his actions on the court’s behalf, his work for the court will be impeded.172 The Commissioners believed that this clarification would (i) allow any trustee, estate neutral, and statutory committee and its members to perform their fiduciary duties with confidence and focus,173 and (ii)  eliminate unnecessary litigation concerning the application of the Barton doctrine and whether the court in which a litigant files the action has subject matter jurisdiction over the dispute.174 For similar reasons, the Commission voted to extend the Barton doctrine to any professionals retained by any trustee, estate neutral, or statutory committee or its members to the extent that the litigation involves the professionals’ representation of such party in a fiduciary capacity. The Commissioners recognized that this recommended principle could also apply to cases filed under other chapters of the Bankruptcy Code. Although the Commission did not study bankruptcy 169 170 171 172 173 28 U.S.C. § 959(a). See, e.g., In re VistaCare Grp., LLC, 678 F.3d 218, 224–25 (3d Cir. 2012). McDaniel v. Blust, 668 F.3d 153 (4th Cir. 2012). In re Linton, 136 F.3d 544, 545 (7th Cir. 1998). Id. (explaining the importance of the Barton doctrine because without it, “[t]he threat of [the bankruptcy trustee] being distracted or intimidated is then very great”). “This concern is most acute when suit is brought against the trustee while the bankruptcy proceeding is still going on.” Id. 174 Courts generally hold that if the Barton doctrine applies and the litigant does not obtain leave of the bankruptcy court, other courts do not have subject matter jurisdiction over the matter. See, e.g., In re Crown Vantage, Inc., 421 F.3d 963, 971 (9th Cir. 2005).  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 51 of Chapter  cases under these other chapters, it believed that the Barton doctrine should apply to all cases and proceedings under the Bankruptcy Code. 6. Valuation Information Packages Recommended Principles: Except as provided in the principles for small and medium-sized enterprise cases, the debtor should compile a “valuation information package” (“VIP”) containing the following information: (i) tax returns for the previous three years (inclusive of all schedules); (ii) annual financial statements (audited if available) for the prior three years (inclusive of all footnotes); (iii) most recent independent appraisals of any of the debtor’s material assets (including any valuations of business enterprise or equity); and (iv) to the extent shared with prepetition creditors and existing or potential purchasers, investors, or lenders, all business plans or projections prepared within the past two years. In connection with any motion filed under section 361, 362, 363, or 364 of the Bankruptcy Code or any chapter 11 plan filed within 60 days after the petition date or date of the order for relief, whichever is later, the debtor should file with 16 1, 20 the court a list of the information included in its VIP, unless the court orders ber 2 ovem otherwise for cause. A party in interest may hived on N copy of the VIP for a proper request a rc 6 a purpose, which includes the evaluation3of the pending motion or proposed plan. -353 . 14 Unless the court ordersrown, No otherwise for cause, the debtor should provide a copy of v. B the VIP promptlyth any such requesting party, provided that the party executes xse to n Bli i cited a confidentiality agreement and, to the extent that the VIP contains material nonpublic information, agrees to restrict its trading activity in the debtor’s claims, interests, and securities. The debtor should be able to redact or withhold information otherwise included in its VIP to the extent that the debtor determines in good faith that such redaction is necessary to prevent harm to the estate, unless the court orders otherwise. Valuation Information Packages: Background A debtor is required to file a variety of forms, schedules, and other information upon commencement of its chapter 11 case or shortly thereafter. The Bankruptcy Code generally gives debtors a short grace period after the petition date to file the required forms,175 and debtors typically can request additional time for the filing of certain materials.176 Nevertheless, a debtor’s timely and full disclosure is a necessary component of the chapter 11 process. Without this basic information, the court, the U.S. Trustee, and parties in interest cannot assess the debtor’s reorganization efforts and make meaningful decisions in the case. 175 Fed. R. Bankr. P. 1007(c), (d). 176 Fed. R. Bankr. P. 1007(a)(5) (permitting extensions of deadlines upon a showing of cause). IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 52 of 402 Bankruptcy Institute The debtor’s financial information is perhaps among the most important of its disclosures. Under current law, a debtor is required to file some, but not necessarily the most relevant financial data early in the chapter 11 case, unless the court orders otherwise for cause. For example, every debtor that files periodic reports with the Securities and Exchange Commission must file “Exhibit A” along with its chapter 11 petition, which requires the debtor to list the value of its assets and the amount of its liabilities plus basic information regarding its capital structure (public and private debt and equity securities). Similarly, section 521(a) of the Bankruptcy Code and Rule 1007 of the Federal Rules of Bankruptcy Procedure (the “Bankruptcy Rules”) require the debtor to file schedules of assets and liabilities and a statement of financial affairs, unless the court orders otherwise for cause. There is no specific requirement that such schedules and statements be prepared in accordance with generally accepted accounting principles (“GAAP”), and extensions of the deadline to file these documents are routinely requested and granted by courts. Separately, the U.S. Trustee requires a debtor to submit its financial information within one week of its petition date, as outlined in the applicable U.S. Trustee’s Operating Guidelines and Reporting Requirements for Debtors in Possession and Chapter 11 Trustees, to facilitate the U.S. Trustee’s oversight functions. The required information includes a list of bank accounts and insurance policies.177 Finally, Bankruptcy Rule 2015 contains additional obligations to disclose financial information relating to inventory, receipts, disbursements, and other relevant matters. Notably, none of these required disclosures provide the court, the U.S. Trustee, or parties in interest 16 with financial data that could assist the parties in valuing the debtor’s ber 21, 20 or assets.178 Such business m valuation information may be critically important early in dthe Nove when a debtor is seeking n case e o iv permission to use cash collateral, obtain debtor in 363 arch possession financing, or sell some or all of its -35 4 assets, and when creditors are seeking reliefNo. 1 stay. from wn, ited h v. xset n Bli i Bro c Valuation Information Packages: Recommendations and Findings The Commissioners analyzed the potential benefits of the requirement that debtors provide additional and earlier disclosures of meaningful financial data, particularly data that may assist parties in interest to assess valuation issues.179 Among other potential benefits, such disclosures may help reduce information asymmetries and allow parties to make better-informed decisions regarding the impact of the debtor’s proposed exit strategy on their recoveries in the case. Such disclosures could 177 The U.S. Trustee also has discretion to request additional information. In addition, the debtor must complete a monthly operating report for filing and submission to the U.S. Trustee. 178 See, e.g., Legislative Update: Valuation Issues a Key Topic at Chapter 11 Commission Hearing in Las Vegas, Am. Bankr. Inst. J., Apr. 2013, at 125 (recommending earlier disclosures about debtor’s business plan and business projections) (citing testimony by Eric Siegert of Houlihan Lokey). 179 Some commentators have expressed dissatisfaction with the current lack of sufficient disclosures by the debtor early in the bankruptcy case. See, e.g., id. (“I’m generally frustrated with the notion of . . . confidentiality around a debtor’s business plan early in the process. I understand that there are competitive secrets and things of that nature that need to be safeguarded, but at the end of the day when you look at a chapter 11 confirmation process, the business projections, almost without exception, are included in a disclosure statement, so they’re made public anyway.”) (citing testimony by Eric Siegert, Houlihan Lokey); id. at 126 (“Creditors’ committees are frustrated by the amount of time [that] it takes for debtors to provide timely and thorough financial information. . . . As a result of this sluggish and time-consuming process of getting information, I believe that committees are often stymied in fulfilling their fiduciary obligations.”) (citing testimony by Sandi Horwitz, CSC Trust Co.). Other commentators have suggested that the debtor’s control of the flow of financial information, imprecise financial data, and the use of strategic valuation can have significant wealth consequences. See, e.g., Stuart Gilson et al., Valuation of Bankrupt Firms, Rev. of Fin. Stud., Spring 2000, at 45–46 (“[S]enior claimants have incentives to underestimate cash flows to increase their recovery in Chapter 11 proceedings. The junior claimants, of course, have the opposite incentive: overestimating value increases their recovery. . . . [V] aluation errors are systematically related to proxies for the competing financial interests and relative bargaining strengths of the participants. . . . [V]aluations are used ‘strategically’ in a negotiation to promote a desired bargaining outcome.”).  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 53 of Chapter  also facilitate more meaningful discussions regarding the debtor’s viable reorganization options earlier in the chapter 11 case. Based on the collective experiences of the Commissioners and recommendations from the advisory committee, the Commissioners identified various kinds of information that may be useful in making early valuation assessments. Such information includes the debtor’s prepetition tax returns, appraisals, and business plans, because these documents would contain information potentially relevant to valuation issues. Some of the Commissioners, however, voiced concerns about the required disclosure of such information, especially relating to the debtor’s business plans. These Commissioners were specifically concerned that the requirement to disclose business plans, including restructuring strategies that would be available to any requesting creditor upon the commencement of the debtor’s chapter 11 case, could result in a chilling effect on chapter 11 filings. The Commissioners therefore acknowledged the need to balance the benefits of additional and earlier disclosures with the likely confidentiality and strategic concerns of a potential chapter 11 debtor. The Commissioners engaged in an in-depth discussion concerning the competing interests and potential value to the estate and stakeholders from additional and earlier disclosures. The Commission found that, on balance, additional and earlier disclosures by the debtor could assist in valuation determinations and should be required in certain specified circumstances. The Commission considered the advisory committee’s recommendation that a debtor should be required to disclose 6 prepetition business plans only to the extent that the debtor shared rsuch 01 1, 2 information with third be 2 parties prior to the petition date; requiring disclosure of this Novem of information would prevent subset d on chive would be similarly situated and on equal information asymmetries and ensure that all stakeholders 3 ar 3536 . 14- the debtor’s financial affairs. Conversely, proprietary footing with respect to their informationoabout ,N own v. Brto withhold from third parties before filing its chapter 11 petition information that a debtor seth elected Blix would be protecteddfrom mandatory disclosure in the case. e in cit To mitigate some of the valid concerns raised by the Commissioners regarding the debtor’s confidentiality and strategy, the Commission agreed that the disclosure obligations should be subject to appropriate provisions regarding confidentiality and fiduciary outs. In addition, the debtor should be required to file only a list of the information included in its VIP if the trustee180 or a party in interest requests certain relief under the Bankruptcy Code. A party in interest would then be able to request copies of such disclosure documents. Finally, the Commission concluded that the additional disclosure information should not be filed with the U.S. Trustee as a matter of course to alleviate a debtor’s confidentiality concerns.181 With these modifications, the Commission approved the recommended VIP as outlined in the principles above. 180 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. 181 The Freedom of Information Act generally applies to information in the possession of the U.S. Trustee. See Freedom of Information Act, http://www.justice.gov/ust/eo/foia/foia_request.htm. The U.S. Trustee’s obligation to comply with FOIA likely would weaken any confidentiality restrictions and intensify a debtor’s concerns regarding confidential and proprietary information. The Commission believed that the debtor and U.S. Trustee will be able to negotiate an acceptable protocol that provides the U.S. Trustee with sufficient information while protecting valid confidentiality and strategic concerns of the debtor. IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 54 of 402 Bankruptcy Institute 7. Professionals and Compensation Issues Recommended Principles: The debtor’s professionals should be clearly identified as either working on matters relating to the chapter 11 case (“chapter 11 professionals”) or on matters unrelated to the chapter 11 case (“nonbankruptcy professionals”). The Bankruptcy Code should define a “nonbankruptcy professional” as an individual or firm of lawyers, financial advisors, accountants, consultants, or other professionals retained by the debtor prior to or after the petition date working exclusively on business or legal matters that arise in, or relate primarily to, the day-to-day operations of the debtor’s business and that could not have a material effect on the chapter 11 case. Only chapter 11 professionals should be subject to sections 327 and 330. The debtor should file with the court a list of its nonbankruptcy professionals with its chapter 11 petition and then subsequently on a quarterly basis. That filing should include the name of each professional and a general description of the work being performed by that professional. The court sua sponte, the U.S. Trustee, 16 , professional or a party in interest should be able to object to the classificationrof1a 20 be 2 m N ve as a nonbankruptcy professional. If the court, afterenoticeoand a hearing, sustains d on rchiv such objection, the professional should be3subject to sections 327 and 330 only on 63 a -35 . 14 a prospective basis. This principleNdoes not obviate the trustee’s need to otherwise , o rown B comply with the U.S.seth v. Trustee’s requirements for quarterly operating reports. lix in B cited To the extent professionals representing ad hoc committees, parties to any agreement or settlement, or secured creditors in the chapter 11 case would be paid their fees and expenses directly or indirectly (e.g., contractual provisions with junior creditors) from the estate under the Bankruptcy Code (either through a substantial contribution motion, the creditors’ proof of claim, the chapter 11 plan, or other order of the court), the approval and payment of their fees and expenses should be subject to the reasonableness standards set forth in section 330(a). Professionals retained by the debtor in possession or any statutory committee should not be considered fiduciaries of the estate. Rather, those professionals’ duties should run to their respective clients and be governed by applicable nonbankruptcy law. A court should be permitted to authorize a trustee or an estate neutral to act not only as an attorney or an accountant for the estate, but also as a professional service provider for the estate to the extent that such authorization is in the best interests of the estate. The employment of a trustee or an estate neutral to act as a professional service provider should remain subject to appropriate limitations and restrictions to avoid self-dealing or other action that is improper or not in the best interests of the estate. Section 327(d) should be amended accordingly.  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 55 of Chapter  Professionals and Compensation Issues: Background Nonbankruptcy Professionals A debtor in possession182 generally must seek court approval to retain professionals to assist it with the chapter 11 case. Specifically, section 327(a) of the Bankruptcy Code provides: “the trustee, with the court’s approval, may employ one or more attorneys, accountants, appraisers, auctioneers, or other professional persons, that do not hold or represent an interest adverse to the estate, and that are disinterested persons, to represent or assist the trustee in carrying out the trustee’s duties under this title.”183 The fees and expenses of professionals retained under section 327 are subject to court approval under section 330 of the Bankruptcy Code.184 The Bankruptcy Code does not define “professional persons” or specifically address the debtor in possession’s ability to hire and pay professionals to assist with nonbankruptcy matters that arise in the operation of the debtor’s business. The one exception to this statement involves lawyers retained for a special purpose. Section 327(e) provides: “The trustee, with the court’s approval, may employ, for a specified special purpose, other than to represent the trustee in conducting the case, an attorney that has represented the debtor, if in the best interests of the estate, and if such attorney does not represent or hold any interest adverse to the debtor or to the estate with respect to the matter on which such attorney is to be employed.”185 In general, courts tend to define “professional” in one 6 of two ways, focusing on whether the entity either (i) plays a central role 1in the administration 1, 20 ber 2in matters concerning the of the estate, or (ii) is allowed to exercise judgment and autonomy vem n No 186 ed o administration of the estate. Accordingly, debtorsainhpossession frequently seek clarification from iv 3 rc -353 the court concerning the scope of “professionals”6retained by the debtor in possession and its ability 14 No. to pay these professionals in the Brown, course of business.187 ordinary v. eth Blixs ed in cit The disinterestedness standard generally requires that the professional not be a creditor or, within the two years before the petition date, a director, officer, or employee of the debtor. It also mandates that the professional not hold “an interest materially adverse to the interest of the estate or of any class of creditors or equity security holders, by reason of any direct or indirect relationship to, connection with, or interest in, the debtor.”188 Some courts interpret disinterestedness strictly, disqualifying any professional holding actual or potential conflicts of interest with the debtor.189 Other courts take 182 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. 183 11 U.S.C. § 327(a). 184 Id. § 330. In addition, the U.S. Trustee has formulated guidelines for reviewing professionals’ fees and expenses in the chapter 11 context. See Guidelines for Reviewing Applications for Compensation and Reimbursement of Expenses, 28 C.F.R. Part 58, Appendices A & B. 185 11 U.S.C. § 327(e). 186 See, e.g., In re Am. Tissue, Inc., 331 B.R. 169, 173 (Bankr. D. Del. 2005) (using six-factor test to evaluate role of entity in case, including those above); In re Fretheim, 102 B.R. 298, 299 (D. Conn. 1989) (focusing on autonomy and judgment factors); In re Seatrain Lines, Inc., 13 B.R. 980, 981 (Bankr. S.D.N.Y. 1981) (focusing on role of entity in administration of estate). But see In re Metro. Hosp., 119 B.R. 910, 916 (Bankr. E.D. Pa. 1990) (defining professional as “someone with special knowledge and skill usually achieved through study and educational attainments whether licensed or not”). See also In re New Orleans Auction Galleries, Inc., 2013 WL 1196680 (Bankr. E.D. La. Mar. 25, 2013). 187 A debtor in possession also may seek authority to pay service providers who are not characterized as professionals and who are retained outside the ordinary course of business under section 363(b) of the Bankruptcy Code. 11 U.S.C. § 327(a). 188 Id. § 101(14)(E). 189 See, e.g., Dye v. Brown (In re AFI Holding, Inc.), 530 F.3d 832, 838 (9th Cir. 2008) (“[B]ankruptcy court did not abuse its discretion in concluding removal was proper due to the Trustee’s past affiliations with insiders that created a potential for a materially adverse effect on the estate and an appearance of impropriety resulting in ongoing disharmony in the estate’s administration.”); In re Marvel Entm’t Grp., Inc.,140 F.3d 463, 476 (3d Cir. 1998) (“(1) Section 327(a), as well as § 327(c), IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 56 of 402 Bankruptcy Institute a more limited view and only disqualify the professional if it holds an interest that is “materially adverse” to the estate.190 Under the current law, debtors in possession will often seek court approval of procedures for retaining and compensating “ordinary course professionals” during the pendency of the chapter 11 case. These procedures typically require the debtor to identify the specific or general types of professionals or service providers covered by the motion and to establish a cap that limits the amounts that can be paid to these entities (usually on a quarterly basis) during the case. Such ordinary course professionals may be required to file a verified statement under Bankruptcy Rule 2014(a), although debtors generally agree to submit quarterly summaries of the fees paid to these professionals. Courts routinely approve motions related to ordinary course professionals to enable a debtor to continue its operations during the chapter 11 case as efficiently as possible. Other Professionals The ability of debtors in possession, trustees or other estate representatives, and statutory committees to retain professionals is subject to approval by the court under section 327 of the Bankruptcy Code; the court thereafter reviews and scrutinizes the compensation requests of professionals under section 330. Other parties in the chapter 11 case may also seek reimbursement for, or payment of, their professionals’ fees and expenses from estate funds. These parties include secured creditors, creditors 16 who are parties to an agreement or settlement with the debtor or the trustee,2parties to intercreditor 1, 20 berhoc committees, a party 191 with ad agreements, and ad hoc committees. In some instances, such as Novem n ed o of the Bankruptcy Code, which may seek payment for its professionals under section 503(b)(3)(D) rchiv 63 a -353 permits the payment of the reasonable fees o. 14 expenses of “a creditor, an indenture trustee, an and ,N own rrepresenting creditors or equity security holders other than a B equity security holder, or a committee th v. lixse n Bsection 1102 of this title, in making a substantial contribution in a case committee appointed iunder ted i c imposes a per se disqualification as trustee’s counsel of any attorney who has an actual conflict of interest; (2) the district court may within its discretion — pursuant to § 327(a) and consistent with § 327(c) — disqualify an attorney who has a potential conflict of interest and (3) the district court may not disqualify an attorney on the appearance of conflict alone.”); In re Martin, 817 F.2d 175, 182 (1st Cir. 1987) (“The question is not necessarily whether a conflict exists — although an actual conflict of any degree of seriousness will obviously present a towering obstacle — but whether a potential conflict, or the perception of one, renders the lawyer’s interest materially adverse to the estate or the creditors.”) (citation omitted); In re Lease-A-Fleet, Inc., 1992 U.S. Dist. LEXIS 407, at *2 (E.D. Pa. Jan. 15, 1992) (“I reject [the] argument that § 327(e) requires disqualification whenever there is a potential conflict. While some courts hold that simultaneous representation of the debtor and its guarantors is prohibited under § 327(e), such is clearly not the rule in this Circuit.”) (citing In re G&H Steel Service, Inc., 76 B.R. 508, 510 (Bankr. E.D. Pa. 1987)). 190 See, e.g., Beal Bank, S.S.B. v. Waters Edge Ltd. P’ship, 248 B.R. 668, 695 (D. Mass. 2000) (quoting In re Martin, 817 F.2d 175, 182 (1st Cir. 1987)) (“[A]n inquiry does not have to ask ‘whether a conflict exists . . . but whether a potential conflict, or the perception of one renders the lawyer’s interest materially adverse to the estate or the creditors.’”) (citations omitted); In re Leslie Fay Cos. Inc., 175 B.R. 525, 536 (Bankr. S.D.N.Y. 1994) (“[R]etention under section 327 is only limited by interests that are ‘materially adverse . . . .’”) (citations omitted). Notably, section 327(a) of the Bankruptcy Code refers to “an interest adverse to the estate” while section 101(14)(E) refers to “an interest materially adverse to the interest of the estate.” 11 U.S.C. § 327(a). 191 “A lock-up agreement — sometimes referred to as a plan-support agreement or restructuring-support agreement — often serves as an integral component of the bankruptcy process by allowing a debtor and its key creditors to memorialize the resolution of their legal and economic disputes and permit that debtor to attempt to confirm its plan and exit bankruptcy as expeditiously as possible.” Kristopher M. Hansen et al., Post-Petition Lock-Up Agreements and Designation Standards Clarified, Am. Bankr. Inst. J., Apr. 2013, at 30. Ad hoc or unofficial committees play an important role in reorganization cases. By appearing as a ‘committee’ of shareholders, the members purport to speak for a group and implicitly ask the court and other parties to give their positions a degree of credibility appropriate to a unified group with large holdings. Moreover, the Bankruptcy Code specifically provides for the possibility of the grant of compensation to “a committee representing creditors or equity security holders other than a committee appointed under section 1102 of this title [an official committee], in making a substantial contribution in a case under chapter 9 or 11 of this title.” In re Nw. Airlines Corp., 363 B.R. 701, 703 (Bankr. S.D.N.Y. 2007) (citing 11 U.S.C. § 503(b) (3)(D)).  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 57 of Chapter  under chapter 9 or 11 of this title.”192 In other instances, the operative loan documents, intercreditor agreement, or other agreement may provide for such payment. Courts generally require a party making a request under section 503(b)(3)(D) to prove “extraordinary efforts” to benefit the estate.193 Some courts also require a showing that the party in fact intended to benefit the estate through such efforts.194 Moreover, if a party establishes a substantial contribution claim under section 503(b)(3)(D), it may also be entitled to reasonable compensation “for professional services rendered by an attorney or an accountant of an entity whose expense is allowable under subparagraph (A), (B), (C), (D), or (E) of paragraph (3) of this subsection, based on the time, the nature, the extent, and the value of such services, and the cost of comparable services other than in a case under this title, and reimbursement for actual, necessary expenses incurred by such attorney or accountant.”195 Trustee and Estate Neutral Issues As suggested above, section 327 generally permits the trustee to retain lawyers, accountants, financial consultants, and other professionals to represent the estate and assist with the administration of the estate and the debtor’s reorganization. These professionals must be disinterested and may not hold interests adverse to the estate.196 Section 327(d), in turn, “permits the court to authorize the trustee, if qualified to act as his own counsel or accountant.”197 Notably, section 327(d) is limited to 16 the trustee and to the trustee (or its firm) acting as lawyer or accountant.2This provision does not 1, 0 ber 2 add value to the estate by account for other professionals who may serve as trustees andNwho could vem n o ed o representing the estate in their professional capacities.hiv 3 arc 536 14-3 No. n, In addition, a chapter 11 trustee. isrsubject to the same compensation provisions applicable to chapter B ow eth v 7 trustees under sectionsixs in Bl 326(a) and 330. In a chapter 7 liquidation, the mechanics of section 326(a) cited 198 work well ; a trustee is compensated based on a percentage of the moneys distributed to parties in interest other than the debtor. In a chapter 11 case, however, the limitations of section 326(a) might serve as a disincentive for a trustee to seek recoveries that would result in a return of funds to equity. In fact, some courts have denied compensation to chapter 11 trustees under section 326(a) when distributions are made to the debtor, or property or value other than money is distributed in the case.199 192 11 U.S.C. § 503(b)(3)(D). 193 See, e.g., In re Granite Partners, L.P., 213 B.R. 440, 445 (Bankr. S.D.N.Y. 1997) (“[C]ompensation is limited to those extraordinary actions . . . that lead to an ‘actual and demonstrable benefit to the debtor’s estate, the creditors, and to the extent relevant, the stockholders.’”) (citations omitted); In re White Motor Credit Corp., 50 B.R. 885, 892 (Bankr. N.D. Ohio 1985) (“‘Extraordinary efforts and remarkable results’ are required for consideration of a premium payment.”). 194 See, e.g., In re Lister, 846 F.2d 55, 57 (10th Cir. 1988) (“Administrative expenses incurred prior to the filing of a bankruptcy petition are compensable under 11 U.S.C. § 503(b)(3)(D), if those expenses are incurred in efforts which were intended to benefit, and which did directly benefit, the bankruptcy estate.”); In re Alert Holdings Inc.,157 B.R. 753, 758 (Bankr. S.D.N.Y. 1993) (court held that “[n]either [the creditor’s] asserted help in forming the ad hoc committee, nor his participation in the multidistrict litigation demonstrates an intent to substantially benefit the debtors’ estates, and any benefit that may have otherwise enured to the estates can be considered unintentional and incidental.”); In re 9085 E. Mineral Office Bldg., Ltd., 119 B.R. 246, 251–52 (Bankr. D. Colo. 1990) (“[T]his Court cannot find that [the creditor’s] efforts were in no way intended to confer a benefit upon the estate as a whole.”). 195 11 U.S.C. § 503(b)(4). 196 11 U.S.C. § 327(a). 197 S. Rep. 95-989, 38 (1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5824. See also 11 U.S.C. § 327(d). 198 See, e.g., Pritchard v. U.S. Trustee, 153 F.3d 232 (5th Cir. 1998) (“The section is consistent with the duty of a Chapter 7 trustee to collect and reduce the property of the bankrupt’s estate to money.”). 199 See, e.g., id. at 237 (declining to follow “bankruptcy courts [that] have interpreted the section to include disbursements other than money within the calculation of a trustee’s maximum compensation”) (collecting cases). In addition, some courts hold that IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 58 of 402 Bankruptcy Institute Professionals and Compensation Issues: Recommendations and Findings Nonbankruptcy Professionals Many professionals employed by a debtor in possession during the course of a chapter 11 case do not consult or work on bankruptcy-related issues. Rather, these professionals perform services that the debtor would have required outside the bankruptcy context and even if the chapter 11 case had not been filed. For example, the debtor may employ lawyers, forensic accountants, tax accountants, and other service providers to help with ordinary course business matters such as patent applications, regulatory compliance, or litigation relating to employee claims or disputes that are not material to the chapter 11 case. The Commission referred to these types of professionals as “nonbankruptcy professionals.” The Commissioners debated the utility of subjecting nonbankruptcy professionals to the retention standards in section 327(a) and the disclosure and reasonableness standards for professionals’ fees and expenses in section 330 of the Bankruptcy Code. The Commissioners discussed the purpose underlying the retention standards of section 327(a). In the case of professionals working on bankruptcy matters that directly impact the estate, the relationships between the professionals and the debtor, creditors, and other stakeholders in the case are material and speak to potential conflicts that could bias the advice and actions of the professionals. Conversely, nonbankruptcy professionals generally do not work on matters that affect the rights of creditors and other 2stakeholders in the 16 1, 0 ber 2 of the estate’s assets. debtor’s estate and do not address the claims of these parties or the ovem allocation nN ed o professionals even if it had not The debtor also would have likely retained these nonbankruptcy hiv 3 arc filed the chapter 11 case; the retention would 4-3536been governed by state law, including state have 1 No. ethical codes for lawyers that address rown, conflicts of interest and fee arrangements. Consequently, the .B eth v Commission agreed that in Blixs nonbankruptcy state laws governing many professions are sufficient to cited protect the interests of the estate with respect to nonbankruptcy professionals. The Commissioners, however, recognized that the work of nonbankruptcy professionals can impact the value of an asset of the estate or the debtor. The advice of nonbankruptcy professionals concerning a certain product or their assessment or management of a particular piece of litigation could underlie a substantial gain or loss by the debtor. The Commissioners discussed examples of nonbankruptcy litigation that could have a material effect on the chapter 11 case. They weighed the costs and benefits of setting a materiality threshold or compensation cap, and whether either such limitation would capture the significant matters with which they were concerned. On balance, the Commission agreed that requiring disclosure of the name of each nonbankruptcy professional and the nature of the services provided by such professional would provide the court, the U.S. Trustee, and parties in interest with sufficient information (and perhaps more meaningful information than that provided by a compensation cap) to determine if the professional should be reclassified as a chapter 11 professional subject to the requirements of sections 327, 328, and 330, even though the professional is not rendering bankruptcy-related services. In addition, the Commission determined that, with respect to professional firms, this classification should be made based on the firm as a whole, not based on the individual professionals in such firm (i.e., if a law firm or financial firm a credit bid by a secured creditor is not moneys for purposes of section 326(a). See, e.g., In re Lan Assocs. XI, L.P., 192 F.3d 109, 116 (3d Cir. 1999); U.S. Trustee v. Tamm (In re Hokulani Square, Inc.), 460 B.R. 763, 777–78 (B.A.P. 9th Cir. 2011).  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 59 of Chapter  is providing bankruptcy-related services in a debtor’s chapter 11 case, the firm’s status is imputed to all professionals, such that all professionals within that firm should be considered chapter 11 professionals). The Commission also considered whether the reasonableness standards of section 330 should apply to the compensation requests of all professionals. Section 330 sets forth a variety of factors that the court should consider in reviewing and approving professionals’ fees and expenses. The court’s review requires meaningful disclosures from the professionals concerning their fees and expenses. Each professional retained by the debtor, unsecured creditors’ committee, and any estate neutral or trustee (collectively, the chapter 11 professionals) is required to file detailed fee applications with the court to facilitate this review. The Commissioners believed that the disclosure and transparency demanded by section 330 was warranted when the professionals’ services directly affected, assisted, or were performed on behalf of the estate and when the requested compensation would be paid by the estate. In these instances, the court, the U.S. Trustee, and parties in interest should have an opportunity to review the specific services performed and whether they justified the use of estate resources. After comparing the roles of chapter 11 professionals versus nonbankruptcy professionals, the Commission determined that only chapter 11 professionals should be subject to the retention and compensation standards of sections 327 and 330. The Commissioners did not believe that the types 16 of services provided by, and the typical compensation paid to, nonbankruptcy professionals warrant 1, 20 ber 2 vem the time and expense associated with compliance under osections 327 and 330. Moreover, they n No ed hiv found that the disclosure about nonbankruptcy 6professionals and their services would adequately 3 arc -353 1 protect the interests of the estate and ,allow 4 No. reclassification if necessary or appropriate. In reaching rown its conclusions, the CommissionB h v. emphasized that nonbankruptcy professionals should include only xset n Bli— on an individual or firm basis — work exclusively on matters unrelated i those professionalsdwho cite to the chapter 11 case. If a professional firm retained by the estate to perform services relating to the chapter 11 case also provides services to the debtor on general litigation or employment matters, for example, that firm and the professionals working at that firm should be considered chapter 11 professionals. Other Professionals The Commission reviewed similar issues and concerns with respect to professional compensation paid by the estate for services provided to secured creditors; creditors who are parties to settlements or agreements with the debtor, trustee, estate or other parties in the case (e.g., intercreditor agreements); and ad hoc committees. The Commissioners recognized that the services of these professionals could add value to a chapter 11 case. Moreover, the payment of the attendant professionals’ fees and expenses is often part of the underlying bargain and is authorized by an order of the court in connection with a substantial contribution motion, a motion to approve the settlement or agreement under the Bankruptcy Code, the creditor’s proof of claim, or the chapter 11 plan. Nevertheless, some of the Commissioners expressed concern that parties often stipulate to the reasonableness of professionals’ fees and expenses, such that they are no longer subject to any meaningful review by the court or other parties in interest. IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 60 of 402 Bankruptcy Institute The Commission considered whether these professionals’ fees and expenses should be subject to a fee application process, but ultimately determined that for these professionals, on balance, the standard of review was more important than the form of disclosures. The Commission also agreed that, to the extent the court disallows any professionals’ fees and expenses under this standard, the creditor or ad hoc committee should not be permitted to seek reimbursement for disallowed fees from other stakeholders in the case. The Commission found that any such reimbursement mechanism would undermine the utility of the reasonableness review in that it could indirectly effect the obligations of the estate to other creditors. In light of the foregoing, the Commission voted to require the review of any professional compensation requested by professionals retained to represent secured creditors, creditors who are parties to agreements or settlements approved by the court, and ad hoc committees under the reasonableness standard of section 330(a) of the Bankruptcy Code. The Commission also agreed that this principle should not otherwise affect the permissibility or authorization of such professionals’ fees and expenses under the Bankruptcy Code and current law. Trustee and Estate Neutral Issues The Commission considered the justifications for limiting the trustee’s professional services to the estate to those provided by lawyers and accountants. Some Commissioners suggested that these particular professional services were identified in section  327(d) because they were the primary services provided to bankruptcy estates at the time section  327 was adopted. Since that time, individuals serving as trustees may have different expertise and professional 21, 2016 This change, capacities. er emb in part, reflects the evolution of bankruptcy cases and the bankruptcy profession. Although lawyers Nov d on chive 11 cases, management consultants, and accountants continue to play important roles in 3chapter ar 536 financial advisors, and other professional service -3 . 14 providers also are actively involved in bankruptcy No wn, cases and can add value to the process. o v. Br eth ixs in Bl cited The Commissioners discussed the potential benefits and cost savings to the estate by permitting a trustee (or its firm) to act as, for example, a management consultant to the estate in connection with operating the debtor’s business and administering the case. Although the Commissioners appreciated the need to ensure thersat professionals representing the estate are disinterested and do not hold adverse interests to the estate, they did not perceive significant issues when appointed trustees seek to perform certain specified professional services for the estate. Moreover, many Commissioners believed that estate neutrals, whom the U.S. Trustee also would determine to be disinterested and qualified, should be able to seek the same authority to represent the estate in their professional capacities. Accordingly, the Commission recommended expanding section  327(d) to include trustees and estate neutrals and to add “professional service provider” to the list of authorized roles for the trustee or estate neutrals. The Commissioners also discussed the compensation structure of section 326(a) and whether it provided proper incentives to trustees to maximize the value of the estate. As explained above, section 326(a) compensates trustees based on a percentage of the amount of moneys distributed or turned over to parties in interest in the case other than the debtor. Some Commissioners suggested modifying section 326(a) to exclude only distributions to “chapter 7 debtors and individual chapter 11 debtors” from the compensation calculation, recognizing the different focus of case administration in chapter 11 cases involving business debtors. These Commissioners noted that the  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 61 of Chapter  exclusion of distributions to the debtor from the compensation calculation could encourage trustees to administer the estate in a manner that restricts recoveries or liquidates assets for the benefit of parties in interest other than the debtor in order to maximize the trustee’s compensation. Other Commissioners suggested that such conduct likely would be a violation of the trustee’s fiduciary duties, which should be a sufficient deterrent of such conduct. The Commissioners debated these points, focusing on the alignment of section 326(a) with a trustee’s fiduciary duties to better serve the estate. The Commission ultimately was not able to reach a consensus on the issue. Nevertheless, several Commissioners believed that certain modifications could add value to cases and eliminate ambiguities in the application of section 326 to chapter 11 business cases.200 8. Costs in Chapter 11 Cases Recommended Principles: The Bankruptcy Code should be clarified to expressly permit professionals retained pursuant to section 327 or 1103 of the Bankruptcy Code to seek the court’s approval, at the outset of the engagement or of a particular matter, of alternative fee arrangements in lieu of the traditional hourly billing model. Such alternative fee arrangements could include the following: fixed fees, flat fees, task16 specific fees, and contingent fees. Courts should assess the reasonableness of, and 1, 20 ber 2 the potential benefits to the estate from, a professional’smproposed alternative fee ve n No ed o arrangement at the time that the court aischiv r evaluating the professional’s original 63 -353 of the matter or engagement that will be retention application or at the. outset 14 , No rown B subject to the proposed alternative fee arrangement. The professional seeking an h v. xset n Bliarrangement should bear the burden of proving by a preponderance alternativei fee cited of the evidence that the arrangement is reasonable, has been thoroughly reviewed with the client, and is reasonably likely to be beneficial to the estate. Section 328 should be clarified to incorporate this approval standard. Once a court has approved an alternative fee arrangement, it should not alter the approved arrangement once the matter or engagement has terminated unless, in accordance with section 328 as it currently provides, the “terms and conditions [of the arrangement] prove to [be] improvident in light of developments not capable of being anticipated at the time of the fixing of such terms and conditions.” Courts should not review alternative fee arrangements under the lodestar method, which is applicable to the hourly billing model. Congress should amend sections 328 and 330 to clarify that alternative fee arrangements based in whole or in part on non-hourly billing models are permitted and subject to review solely under section 328, in accordance with the changes proposed in these principles. 200 Such beneficial modifications to section 326(a) might include limiting the exclusionary language of that section to “chapter 7 debtors and individual chapter 11 debtors” (rather than “the debtor”) and expanding the concept of disbursements to moneys, property, or other value disbursed or turned over to parties in interest. IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 62 of 402 Bankruptcy Institute Costs in Chapter 11 Cases: Background A common critique of chapter 11 is that it is too expensive: distressed companies cannot afford to file for bankruptcy and engage in the process of reorganizing under the protections of the Bankruptcy Code.201 Although commentators debate the accuracy of this statement, the perception persists that chapter 11 is cost-prohibitive for many distressed companies. The chapter 11 process is not free. It introduces costs into a company’s budget that do not exist outside the bankruptcy context.202 The debtor in possession also must retain and compensate bankruptcy professionals to assist with its chapter 11 case.203 Importantly, the debtor’s estate is also responsible for paying the fees and expenses of bankruptcy professionals that are retained by any statutory committees, examiners, and trustees that are appointed in the debtor’s chapter 11 case.204 The estate’s administrative outlay for professionals’ fees is often the focal point of debates concerning the costs of chapter 11.205 Headlines such as Extra! Extra! Tribune Fees Top $150 Million,206 and American Airlines Bankruptcy Advisors Seek $400 Million in Fees, Expenses207 catch the attention of 201 One prominent bankruptcy attorney at a major law firm observed that “bankruptcy has become so expensive that, ironically, poor companies or businesses with no cash cannot afford to go through the procedure.” Natalie Posgate & Mark Curriden, American Airlines Insiders Provide Exclusive Behind-the-Scenes Recap of Historic Bankruptcy and Merger, Texas Lawbook (2014), available at http://www.law.smu.edu/getmedia/7430e732-144d-4fbf-ba3a-3273d2be862b/American-Airlines-Insiders-Reprint. Another seasoned turnaround consultant opined that “the cost of bankruptcy has gotten so high — because of professional and 16 other costs — that the ability to continue the company under current ownership has reached almost,zero.” Ian Mount, Adviser to 1 20 ber 2 m Businesses Laments Changes to Bankruptcy Law, N.Y. Times (Feb. 29, 2012). Nove 202 For example, currently a company must submit a filing fee of $1,717.00 to d onbankruptcy court along with its petition to e thein possession also must remit quarterly fees to commence a chapter 11 case. During the pendency of its chapter 11 case, a debtor rchiv 63 a the Office of the U.S. Trustee, which are calculated each quarter5based on the amount the debtor disbursed during such quarter. -3 3 o 14 These fees currently range from $325 (for disbursement. of $0 to $14,999.99) up to $30,000 (for disbursements of $30,000,000 n, N or more). Pursuant to 11 U.S.C. § 1930(b),Brow the Judicial Conference prescribes filing fees in all cases under the Bankruptcy v. Code. The current schedule of feesxeffective as June 1, 2014 is available at http://www.uscourts.gov/FederalCourts/Bankruptcy/ seth n Bli i BankruptcyResources/BankruptcyFilingFees.aspx. Bankruptcy courts enforce these filing fees. See, e.g., Fee Schedule, United cited States of Bankruptcy Court, District of Delaware (effective June 1, 2014), available at http://www.deb.uscourts.gov/fee-schedule; Fee Schedule, United States of Bankruptcy Court, Southern District of New York (effective June 1, 2014), available at http://www. nysb.uscourts.gov/sites/default/files/pdf/filingFees.pdf. 203 The Administrative Office of the U.S. Courts on behalf of the Federal Judiciary advises that “[c]orporations and partnerships must have an attorney to file a bankruptcy case. While individuals can file a bankruptcy case without an attorney or ‘pro se,’ it is extremely difficult to do it successfully.” Filing for Bankruptcy Without an Attorney, http://www.uscourts.gov/FederalCourts/ Bankruptcy/BankruptcyResources/FilingBankruptcyWithoutAttorney.aspx. 204 Bankruptcy Code section 330 provides for compensation of all professionals — not just professionals retained by the debtor — whose retention was approved by the court. Specifically, section 330(a) provides, in relevant part: [T]he court may award to a trustee, a consumer privacy ombudsman appointed under section 332, an examiner, an ombudsman appointed under section 333, or a professional person employed under section 327 or 1103 — (A) reasonable compensation for actual, necessary services rendered by the trustee, examiner, ombudsman, professional person, or attorney and by any paraprofessional person employed by any such person; and (B) reimbursement for actual, necessary expenses. 11 U.S.C. § 330(a). A 2007 comprehensive study of professionals’ fees in bankruptcy revealed that “[c]ommittee professionals cost the estate about two-fifths of what the debtor’s professionals cost.” Jesse Greenspan, Time Spent In Chapter 11 Doesn’t Affect Costs: Study, Law 360 (Dec. 7, 2007, 12:00 AM), http://www.law360.com/articles/41896/time-spent-in-chapter-11-doesnt-affect-costs-study. 205 But see Lubben, What We “Know” About Chapter 11 Cost is Wrong, supra note 44, at 144 (“[T]oo much of the debate about chapter 11 costs rests on a false premise . . . that professional fees in bankruptcy represent nothing more than wealth transfers, taking value from creditors and giving it to bankruptcy professionals”). A recent study of professionals’ fees found that “[i]n almost 35% of [chapter 11] cases, professionals received no payment whatsoever,” and typically these cases were smaller and were often converted to chapter 7 or dismissed. Greenspan, supra note 204. Based on a 2008 study of professionals’ fees, Professor Lubben concluded that factors like the size of the debtor, the number of professionals retained, and whether a committee is appointed, which are all proxies for the complexity of the case, have much more significant effects on costs, as compared to the time spent in chapter 11, and that professionals’ fees in chapter 11 are subject to economies of scale, especially in larger cases. Stephen J. Lubben, Corporate Reorganization & Professional Fees, 82 Am. Bankr. L.J. 77, 79–80 (2008). 206 Eric Morath, Extra! Extra! Tribune Fees Top $150 Million, Wall St. J. Blog (May 25, 2011, 3:54 PM), http://blogs.wsj.com/ bankruptcy/2011/05/25/extra-extra-tribune-fees-top-150-million/. 207 Sara Randazzo, American Airlines Bankruptcy Advisers Seek $400 Million for Fees, Expenses, Wall St. J. (June 26, 2014, 4:20 PM), http://online.wsj.com/articles/american-airlines-bankruptcy-advisers-seek-400-million-for-fees-expenses-1403814038.  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 63 of Chapter  policymakers and the public alike, but a look behind the numbers cited in these headlines may reveal a different story.208 In fact, empirical studies show that the total amount in professionals’ fees in a chapter 11 case is generally a modest percentage of the debtor’s assets, revenues, and distributions to creditors.209 But these studies do not change the perception — whether or not accurate — that every dollar an estate pays in chapter 11 costs is one less dollar available to pay creditors.210 As pointed out by one professor who has studied professionals’ fees extensively, this perception necessarily ignores the value that professionals add to the estate during the pendency of a chapter 11 case for the benefit of all parties in interest.211 The U.S. Trustee and some commentators have criticized not only the overall amount of professionals’ fees, but also the hourly rates of bankruptcy professionals, particularly in large chapter 11 cases.212 The Office of the U.S. Trustee, for example, has raised concerns about lawyers charging hourly rates of $1,000 or more in some of the larger chapter 11 cases.213 These and other compensation concerns recently led the Office of the U.S. Trustee to propose and ultimately adopt fee guidelines specifically applicable to professionals in chapter 11 cases involving $50 million or more in assets or liabilities.214 208 It is noteworthy that the court-appointed fee examiner recommended that the bankruptcy court approve the fees and expenses for 47 professional firms in the American Airlines case in the amount of nearly $400 million, noting that these professionals engineered “perhaps the most efficient airline reorganization case on record.” Id. (The fee examiner in the American Airlines case was Robert Keach, Co-Chair of the Commission. In addition, several other Commissioners were involved in the American Airlines case.) Indeed, the value created in the merger of American Airlines and US Airways as part of American Airlines’ reorganization plan resulted in all of American Airlines’ creditors receiving full value on their claims and American Airlines’ shareholders receiving shares amounting to approximately 40 percent of the merged company —16 a market cap that exceeded at the stand-alone value of American Airlines at any prior point in its history. Scholars have21, 20 r not analyzed whether the cost of fee be examiners exceeds their benefit to the estate. ovem 209 Professor Lubben’s study revealed that across all bankruptcy cases, and evenon N large chapter 11 cases specifically, professionals’ across d fees totaled 4.0 percent to 4.5 percent of the sum of the debtor’s assets ive debts. Lubben, Corporate Reorganization & Professional archand 363 These results are consistent with earlier fee studies. Based on a Fees, supra note 205, at 103. See also Greenspan, supra -35 note 204. o. 4 2004 study of large chapter 11 reorganization,cases 1 from 1980 through April 2003, Professors LoPucki and Doherty found n Nlessfiled 3 percent of their total assets to pay for professionals’ fees. Lynn M. that some of the largest debtor cases Brow expended than th v. LoPucki & Joseph W. Doherty,eThe Determinants of Professional Fees in Large Bankruptcy Reorganization Cases, 1 J. Empirical lixs Legal Stud. 111, 140 d in B (“For a group of 48 firms with assets ranging from about $65 million to $7.5 billion, and averaging ite (2004) $881 million, wecfound that total fees and expenses were 1.4 percent of total assets reported in the court file at the beginning of the bankruptcy case, and that firms expended, on average, 2.2 percent of assets on professional fees (1.9 percent after the removal of a single outlier).”). Professors LoPucki and Doherty explained that economies of scale were at play in large chapter 11 cases, such that the larger the debtor, the lower the ratio of restructuring fees and expenses the debtor incurred relative to its assets. Id. at 126. Earlier, Professor Baird also observed that the direct costs of bankruptcy for large, publicly traded companies was relatively small, between 0.9 percent and 7.0 percent, and an average of 2.8 percent, of the book value of the assets before the filing of the bankruptcy petition, which was comparable to or less than the costs of an initial public offering, private placement, or leveraged buyout. Douglas G. Baird, The Hidden Virtues of Chapter 11: An Overview of the Law and Economics of Financially Distressed Firms, Coase-Sandor Inst. for L. & Econ. Working Paper No. 43, 1997, at 11–12, available at http://chicagounbound. uchicago.edu/law_and_economics/527/. 210 Under Bankruptcy Code section 503(b)(2), “compensation and reimbursement awarded under section 330(a) of [the Bankruptcy Code]” are classified as “administrative claims.” 11 U.S.C. § 503(b)(2). Section 507, which sets forth the priority order for the payment of unsecured creditors, elevates the payment of “administrative expenses allowed under section 503(b)” above the payment of all other unsecured debts (except domestic support obligations). 11 U.S.C. § 507(a)(1). Therefore, in a chapter 11 case that cannot support full recoveries to all creditors, administrative claims reduce the amount of funds that will be available for distribution to unsecured creditors. 211 “Being in chapter 11 means that creditors’ recovery on their claims becomes higher than zero. The professional fees are the cost of moving to that higher recovery. The notion that money paid to professionals belongs to creditors is true only if the creditors could realize that value without the professionals.” Lubben, What We “Know” About Chapter 11 Cost is Wrong, supra note 44, at 144. “The cost paid to chapter 11 professionals is an example of the old truism that sometimes you have to spend money to make money. In chapter 11, creditors have to spend some money to recover some of what is due to them. In the main, the value of chapter 11 professionals’ time was never a value that creditors could capture. Pretending that fees paid to professionals represents a real loss to the creditors demonstrates little more than muddled thinking.” Id. at 145. 212 Nancy B. Rapoport, Rethinking Professional Fees in Chapter 11 Cases, 5 J. Bus. & Tech. L. 263, 270–271 & n. 28 (2010), available at http://digitalcommons.law.umaryland.edu/jbtl/vol5/iss2/5 (summarizing published criticisms of professionals’ fees in chapter 11 context). 213 Jacqueline Palank, $1,000/Hour Bankruptcies: Attorneys Justify Their Fees, Wall St. J. (June 3, 2012, 6:29 PM) (“The Justice Department has grown increasingly restless with attorney fees — often exceeding $1,000 an hour — paid by companies going through a bankruptcy reorganization.”). 214 The new fee guidelines became effective for cases filed on or after November 1, 2013. Appendix B — Guidelines for Reviewing Applications for Compensation and Reimbursement of Expenses Filed Under 11 U.S.C. § 330 by Attorneys in Larger Chapter 11 Cases, 78 Fed. Reg. 36,248, 36,249 (June 17, 2013), available at http://www.justice.gov/ust/eo/rules_regulations/guidelines/docs/ Fee_Guidelines.pdf [hereinafter UST Fee Guidelines]. “Generally, the final guidelines provide for a showing that rates charged IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 64 of 402 Bankruptcy Institute The stated goals of the new fee guidelines are to, among other things, “ensure that bankruptcy professionals are subject to the same client-driven market forces, scrutiny, and accountability as professionals in nonbankruptcy engagements;” “increase disclosure and transparency in the billing practices of professionals seeking compensation from the estate;” and “increase public confidence in the integrity and soundness of the bankruptcy compensation process.”215 Notably, only a small number of chapter 11 cases fall within these new fee guidelines.216 Additionally, the increasing cost of chapter 11 has had a significant impact on the perceived ability — and perhaps actual ability — of small and middle-market companies seeking restructuring options to invoke chapter 11.217 One commentator observed that, based on a small sampling of cases filed in 2010 in the Southern District of New York, “professional fees for the middle-market Chapter 11 cases typically approached or exceeded $1 million.”218 This commentator suggested that high professionals’ fees, among other factors,219 have encouraged lawyers representing middle-market companies to pursue alternatives to traditional chapter 11 reorganization, such as section 363 asset sales on an expedited basis, followed by a liquidating plan, or to invoke alternatives under state law, including general assignments for the benefit of creditors and composition agreements to restructure debt.220 Although this particular study was limited in size and geographic area, the commentator’s findings mirror the testimony and anecdotal evidence presented to the Commission during its study process.221 16 215 216 217 218 219 220 221  , 20 reflect market rates outside of bankruptcy; the use of budgets and staffing plans; the disclosure of rate increases that occur during er 21 the representation; the submission of billing records in an open, searchable electronicoformat; and the use of fee examiners and emb v ‘efficiency’ counsel.” Statement of Clifford J. White III, Director, Executive OfficeoforN d n United States Trustees, U.S. Department of Justice, before the Subcomm. on Regulatory Reform, Commercial and Antitrust Law of H. Comm. on the Judiciary, at 10 (Sept. 19, chive ar 2014) [hereinafter White Statement]. For a one-page summary5of63 UST Fee Guidelines prepared by the U.S. Department of 3 3 the . 14Justice, see Summary of Material Differences from n, No 1996 Guidelines, http://www.justice.gov/ust/eo/rules_regulations/guidelines/ ow docs/One_Page_Summary_AppxB_Guidelines.pdf. See also Marina Fineman, For Lawyers Only: New Fee Application Guidelines v. Br eth for Attorneys in Large Chapter 11 lCases, ABI Ethics & Professional Compensation Committee News, Vol. 10, no. 4, available at B ixs http://www.abiworld.org/committees/newsletters/ethics-and-professional-compensation/vol10num4/lawyers.html. ed in cit UST Fee Guidelines, supra note 214, at 36,251–36,254. See also White Statement, supra note 214, at 10 (explaining objectives underlying study of fees leading to new fee guidelines as including “(1) ensur[ing] that fee review is subject to client-driven market forces, accountability, and scrutiny; (2) enhance[ing] meaningful disclosure and transparency in billing practices; (3) decreas[ing] the administrative burden of review; (4) maintain[ing] the burden of proof on the fee proponent; and (5) increase[ing] public confidence in the integrity and soundness of the bankruptcy compensation process”). The UST Fee Guidelines apply only to the so-called mega-chapter 11 cases, which are referred to as “larger chapter 11 cases.” A “larger chapter 11 case” is defined as “a chapter 11 case with $50 million or more in assets and $50 million or more in liabilities, aggregated for jointly administered cases and excluding single asset real estate cases as defined in 11 U.S.C. § 101(51B).” UST Fee Guidelines, supra note 214, at 36,249. See also Fee Guidelines for Attorneys in Larger Chapter 11 Cases, http://www.justice. gov/ust/eo/rules_regulations/guidelines/; White Statement, supra note 214, at 10 (“To date, 61 cases have been filed to which the guidelines apply, and we are monitoring them closely.”). With respect to small and middle-market companies, “if they have to go into Chapter 11, the odds of the owners keeping the business are much lower. So there’s no incentive for the owners to enter Chapter 11 and reorganize. Why save a company for somebody else?” Mount, supra note 201. Jeffrey A. Wurst, Is Chapter 11 Still a Viable Option or Has High Cost Rendered the Process Unaffordable?, ABJ Journal, Mar. 2013, at 57. “There are several reasons why traditional reorganizations have been sparse. Amongst them are: 1.) the high cost of professional fees; 2.) uncertainty as to the outcome; 3.) lack of availability of unencumbered assets that otherwise may be utilized to secure a DIP lending facility or to fund post-petition obligations under a plan of reorganization; and 4.) alternatives such as out-of-court restructurings and assignments for the benefit of creditors.” Id. at 56. “Liquidating Chapter 11 cases, for better or worse, have been the rule and not the exception in this Court and others over the last decade, if not longer.” Id. (quoting In re Applied Theory Corp., Case No. 02-11868 (Bankr. S.D.N.Y. Apr. 24, 2008) (Gerber, J.)). A study of approximately 60 chapter 11 cases filed in 2010 in the U.S. Bankruptcy Court for the Southern District of New York concluded that alternatives to chapter 11 proved to be more affordable for middle-market debtors. For example, although professionals’ fees typically approached or exceeded $1 million for a chapter 11 reorganization, “sales of assets pursuant to § 363 of the Bankruptcy Code, coupled with a structured dismissal, resulted in significantly lower fees, especially in those cases where the sale was conducted very early in the proceedings.” Id. at 57. “Out-of-court restructurings have become a more favorable alternative by streamlining the restructuring process allowing cost savings to be passed down to the creditor body.” Id. Assignments for the benefit of creditors (“ABCs”) as well as composition agreements to restructure debt have become low-cost alternatives to chapter 11 reorganization, and in some cases, even alternatives to section 363 sales. Id. See, e.g., John Haggerty, Written Statement to the Commission (Apr. 19, 2013) (“In the last ten years, there has been an increase in the use of out-of-court alternatives . . . because the process is too time consuming and complex, and as a result, too costly.”), available at Commission website, supra note 55; The Honorable Dennis Dow, Written Statement to the Commission (Apr. 19, 2013) IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 65 of Chapter  Costs in Chapter 11 Cases: Recommendations and Findings The costs associated with chapter 11 and the desires to make the chapter 11 process more efficient and cost-effective were among the central themes of the Commission’s study. The Commission was mindful that improving the utility of chapter 11 would do little for distressed companies if the process was perceived to be — or was in fact — cost-prohibitive. The Commission was keenly aware that tackling this issue would require most Commissioners to ask hard questions about their own practices and those of their colleagues, who are not only bankruptcy professionals in chapter 11 cases, but who are also, in many instances, subject to the U.S. Trustee’s new fee guidelines. Nevertheless, the Commission agreed that it could and would perform this task because it believed that addressing chapter 11 costs is necessary for effective chapter 11 reform. The Commissioners discussed the various costs associated with filing a chapter 11 case and continuing to conduct business as a debtor in possession.222 The Commission focused its inquiry on several factors that may contribute to the increasingly high cost of chapter 11. These factors included the prolonged duration223 and complexity of a case leading to inefficiencies, the use of strategic or protective litigation in the case by the debtor or other stakeholders, the inherent uncertainty about the outcome of certain processes or legal standards that become the subject of litigation, and the professionals’ fees and expenses incurred in connection with the case.224 The Commission considered various ways to mitigate each of these factors. 16 1, 20 ber 2 strived to develop reform To improve the efficiency of, and certainty in, the process, the Commission vem n No ed o principles to achieve these objectives in different aspects of chapter 11. For example: rchiv 63 a -353 . 14 , No rown The Commission identified, analyzed, and, wherever possible, recommended principles to .B eth v resolve splits Blixs case law governing chapter 11 cases to reduce the need for litigation n in the i cited and provide greater certainty about outcomes. To this end, the Commission sought to resolve the following splits, among others: (“The process of preparing a disclosure statement, obtaining approval of that document, soliciting creditor votes and satisfying the numerous requirements to obtain confirmation of the plan takes time and money. Adding to the costs is the requirement that the Chapter 11 debtor pay the costs of professional fees incurred by other entities in the case, such as creditor’s committees. Provisions offering accommodations for small business debtors have been in the Code for some time, but do not appear to have alleviated these problems.”), available at Commission website, supra note 55; Daniel Dooley, Statement to the Commission, at 37 (Apr. 19, 2013) (ASM Transcript) (“It’s really widely understood and agreed, I think, in the community right now, that Chapter 11 just isn’t cost-effective in the middle market. It doesn’t really provide an opportunity of companies to rehabilitate themselves. . . . So people believe and I think I’m in this category as well, that Chapter 11 and the middle market is simply too slow, and it’s simply too costly for almost all the cases.”), available at Commission website, supra note 55; Professor George Kuney, Written Statement to the Commission (Nov. 7, 2013) (“The number of middle-market and smaller businesses entering chapter 11 and emerging as viable enterprises is falling. Administrative costs for plans in middle-market and smaller cases are too high and as a result, debtors are increasingly relying on numerous alternatives to the traditional chapter 11 process.”), available at Commission website, supra note 55. 222 As suggested above, the filing fee is relatively modest and the quarterly fees owed to the U.S. Trustee are largely scaled to a debtor’s business size, measured by the debtor’s disbursements as reported in its debtor’s monthly operating reports. Although these fees may be difficult for some debtors to pay, as a general matter neither fee is unduly burdensome, and the proceeds from these fees support the oversight and administration of the chapter 11 case. 223 The general consensus of the Commissioners was that the duration of chapter 11 cases was perceived as a cost enhancer. Notably, this perception is refuted by Professor Lubben’s studies. See generally Lubben, Corporate Reorganization & Professional Fees, supra note 205; Lubben, What We “Know” About Chapter 11 Cost is Wrong, supra note 44. 224 These conclusions are consistent with a comprehensive fee study conducted by Professor Lubben. See Lubben, Corporate Reorganization & Professional Fees, supra note 205. Professor Lubben found that “factors such as the retention of several additional professionals and the appointment of an unsecured creditors’ committee are big factors that determine how much a chapter 11 reorganization ultimately costs. These factors are proxies for the size of the debtor and, more directly, the complexity of its reorganization.” Id. at 80. “The complexity of the bankruptcy and the compensation structure for the professionals retained (which may itself reflect further aspects of complexity) are the key determinants of cost.” Lubben, What We “Know” About Chapter 11 Cost is Wrong, supra note 205, at 147. IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 66 of 402 Bankruptcy Institute o The standard of review applicable to the appointment of a chapter 11 trustee under section 1104;225 o The permissibility of cross-collateralization and roll-up provisions in postpetition financing facilities;226 o The proper use of the doctrine of necessity in chapter 11 cases;227 o The ability of drop shipment transactions to qualify for administrative claim treatment under section 503(b)(9);228 o The interplay between the priority afforded to wage claims under section 507(a)(4) and the priority afforded to employee benefit plan claims under section 507(a)(5);229 o The ability of a debtor to apply section 1114 to terminate retiree benefit plans that the debtor has the right to unilaterally terminate outside the bankruptcy context;230 o The definition of “executory contract” for purposes of section 365;231 o The effect of rejecting an executory contract or unexpired lease under section 365;232 o The ability of a debtor to assume intellectual property licenses under section 365(c) (i.e., the hypothetical test versus the actual test)233 and the treatment of trademark 6 , 201 licenses generally;234 er 21 o o b ovem on N The proper calculation of a landlord’s archivedagainst the estate (i.e., the accrual claim 3 approach versus the billing date 14-3536 approach);235 . , No rown B The applicationseth v. safe harbor in section 546(e) to bar fraudulent transfer actions x of the n Bli i cit d broughteunder applicable nonbankruptcy law (i.e., state laws including the Uniform Fraudulent Transfer Act or similar statutes as adopted in each state);236 o The treatment of ordinary supply contracts as qualified financial contracts subject to the protection of the Bankruptcy Code’s safe harbor provisions;237 o The meaning of “for the benefit of the estate” under section 550;238 o The fiduciary duties of a debtor (as opposed to a debtor in possession) proposing a chapter 11 plan;239 225 226 227 228 229 230 231 232 233 234 235 236 237 238 239  See Section IV.A.2, The Chapter 11 Trustee. See Section IV.B.2, Terms of Postpetition Financing. See Section IV.D.1, Prepetition Claims and the Doctrine of Necessity. See Section V.E.1, Section 503(b)(9) and Reclamation. See Section IV.D.2, Wage and Benefits Priorities. See Section V.D.2, Retiree Benefits and Section 1114. See Section V.A.1, Definition of Executory Contract. See Section V.A.3, Rejection of Executory Contracts and Unexpired Leases. See Section V.A.4, Intellectual Property Licenses. See Section V.A.5, Trademark Licenses. See Section V.A.6, Real Property Leases. See Section IV.E.1, Scope of Section 546(e) Safe Harbors. See Section IV.E.3, Assumption of Financial Contracts. See Section V.C.2, Recoveries Under Section 550. See Section IV.A.5, Estate Fiduciaries. IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 67 of Chapter  o The fiduciary duties of professionals paid from the estate;240 and o The permissibility of gifting241 and nonconsensual third party releases242 in the context of a chapter 11 plan. The requirement that a debtor identify and disclose information relevant to valuation issues earlier in the case should provide a more transparent and expedient chapter 11 process for all parties in interest.243 The creation of an “estate neutral” offers the court, the debtor, and other parties in interest a tool to more cost-effectively investigate and resolve disputes and other potential barriers to a debtor’s reorganization efforts.244 The enhanced procedures governing a debtor’s request to modify or terminate a collective bargaining agreement under section 1113 should encourage (i) the debtor to initiate this process earlier in the case and (ii) both the debtor and authorized representatives to undertake meaningful negotiations before moving forward with litigation strategies.245 A clear set of rules governing a sale of all or substantially all of a debtor’s assets in chapter 11 — with appropriate protections and adequate time to allow the court, the debtor’s stakeholders, and potential bidders to identify and resolve issues relating to the debtor’s proposed exit strategy — should reduce delay, diminish the risk of losing value for the 016 estate, and should simplify and expedite procedures.246 ber 21, 2 ovem on N ed down a chapter 11 plan without the need The ability of a debtor or plan proponent torchiv cram 63 a -353claims should eliminate (i) manipulative, strategic, to have an accepting impaired o. 14 of class ,N rown the debtor and creditors (e.g., class construction, acquiring B and tactical maneuvering by h v. xset n Bli blockinged i positions within classes, etc.), and (ii) litigation concerning classification and cit impairment issues and focus the confirmation process on the merits of the plan.247 Similarly, the refinement of the absolute priority rule to permit distributions to junior creditors when supported by the reorganization value and redemption option value in the case,248 as well as the codification of the new value corollary,249 should reduce litigation and expedite the confirmation process. Specific guidelines tailored for small and medium-sized enterprises should streamline and simplify the chapter 11 process for these kinds of debtors and eliminate litigation and expense concerning the new value corollary, the absolute priority rule, and the section 1129(a)(10) issues that are prevalent in these cases.250 240 241 242 243 244 245 246 247 248 249 250 See Section IV.A.7, Professionals and Compensation Issues. See Section VI.C.6, Class-Skipping and Intra-Class Discriminating Distributions. See Section VI.e.3, Third Party Releases. See Section V.F, General Valuation Standards. See Section IV.A.3, The Estate Neutral. See Section V.D.1, Collective Bargaining Agreements Under Section 1113. See Section V.B, Use, Sale, or Lease of Property of the Estate. See Section VI.F.1, Class Acceptance Generally and for Cramdown Purposes. See Section VI.C.1, Creditors’ Rights to Reorganization Value and Redemption Option Value. See Section VI.C.2, New Value Corollary. See Section VII, Proposed Recommendations: Small and Medium-Sized Enterprise (SME) Cases. IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 68 of 402 Bankruptcy Institute The Commission also discussed the increased costs imposed on the estate by professionals’ fees and expenses in a chapter 11 case. In this context, the Commissioners reflected on the testimony of field hearing witnesses regarding the costs of chapter 11, including the following testimony by Wilbur Ross: The most persistent investor complaint about the Chapter 11 process is the level of professional fees. . . . I believe there are several reasons for the high level of fees. At the onset of a case and sometimes even well into it, it is difficult for the judge to decide how many constituencies may be out of the money. This can lead to a proliferation of committees . . . The second problem is that committees whose claims are at or near the cusp of worthlessness have every reason to delay the case in the hope that the Debtor’s business may turnaround . . . The third problem is the individual large creditor or ad hoc group of such creditors who may or may not be on the official committee for that class but who in any event play a proactive individual role in the proceeding and ultimately seek reimbursement of professional fees based on the argument of “substantial contribution.”251 The Commissioners engaged in an in-depth review of professionals’ fees and expenses in chapter 11. The Commissioners started this process by discussing the history and evolution of professionals’ fees in bankruptcy. The state of professionals’ fees prior to the Bankruptcy Code can be summarized as follows: 016 2 r 21, be Under the former Bankruptcy Act, the “economy of administration” standard ovem on N prevailed. That standard required the courts archconsider the public interest in to ived 363 -3 conserving and administering the estate4as5efficiently as possible. Many concluded o. 1 n, N w that this standard effectively rkept the “best and brightest” attorneys out of the .Bo eth v lixsthey could make more in other fields.252 bankruptcy practice, as in B ited c The Commissioners examined pre-Bankruptcy Code practices and generally agreed that bankruptcy professionals often were characterized as “second-class” citizens under the Bankruptcy Act. They did not believe that returning to an “economy of administration” system was a productive pursuit because of its deterrent effect and the resulting negative impact it could have on debtors and their stakeholders in chapter 11 cases. In rejecting the pre-Bankruptcy Code system, the Commissioners acknowledged that any reforms to professionals’ fees in bankruptcy needed to address the criticism that a market does not exist to control or monitor such fees. Indeed, some commentators suggest that bankruptcy professionals set the standards for fees of professionals in other transactional disciplines. Some Commissioners refuted this criticism, noting that the rates of bankruptcy professionals are in fact determined by the market and must be comparable to the rates that such professionals charge clients outside the bankruptcy context.253 The Commissioners also observed that the criticism may not apply 251 Wilbur Ross, Written Statement to the Commission (Apr. 19, 2013), available at Commission website, supra note 55. 252 Clifford J. White III & Walter W. Theus, Jr., Professional Fees Under the Bankruptcy Code: Where Have We Been and Where Are We Going?, Am. Bankr. Inst. J., Dec. 2010/Jan. 2011, at 22. 253 See Lubben, What We “Know” About Chapter 11 Cost is Wrong, supra note 44, at 147 (“[I]f the market is efficient the professionals are limited in their ability to overcharge. Even if the market is somewhat inefficient, we have to ask if the market is any more inefficient than the larger market for corporate professionals. Bankruptcy professionals seem to be easy to pick on, because their fees are disclosed in open court. However, one might suspect that this same fact may also make them more conservative in their billing.”).  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 69 of Chapter  to all bankruptcy professionals, but may be most applicable in the larger chapter 11 cases. Many Commissioners highlighted that the amount of fees and expenses ultimately charged by bankruptcy professionals is driven largely by the complexity of the chapter 11 case and, perhaps more importantly, by the litigious and contentious posture of a case.254 Regardless, the Commissioners believed that all criticisms of, and potential issues with, the current treatment of bankruptcy professionals’ fees had to be considered in studying any reforms, which many Commissioners believed should focus on aligning incentives with case efficiency. The Commission reviewed several large chapter 11 cases in which professionals’ fees and expenses garnered media attention, such as the American Airlines and Tribune Co. cases, as well as City of Detroit, even though it is a chapter 9 case.255 In these cases, either the complexity (in the case of American Airlines)256 or the novelty (in the case of City of Detroit)257 of the issues presented and the litigation initiated by stakeholders to protect or pursue their interests in the case (in the case of Tribune),258 or some combination of these factors, contributed to the relatively large amount of professionals’ fees and expenses that were incurred in these particular chapter 11 cases.259 The Commissioners debated whether the Bankruptcy Code could or should scrutinize more closely the conduct of clients and professionals in these circumstances to try to regulate professionals’ fees. Such ex post oversight by the court, particularly with respect to what actions lawyers should or should not have taken on behalf of their clients, could raise ethical issues for lawyers in chapter 11 cases.260 Indeed, lawyers generally are required to defer to their clients in service of their clients’ 16 “reasonable and necessary” lawful objectives.261 Moreover, professionals are already subject to the 21, 20 ber vem n No ed o rchiv 63 a 254 See supra note 224. -353 o. 14 255 In the American Airlines and City of DetroitNcases, the courts approved the use of fee examiners to review and control n, professionals’ fees and expenses in v. Bcases. Notably, the UST Fee Guidelines “encourage greater use of fee examiners to help the row th evaluate technical compliances(e.g., no lumping of tasks into a single time entry) and assess the reasonableness of a fee request.” lix e Cliff J. White III, New FeeB ed in Guidelines for Attorneys in Larger Chapter 11 Cases Enhance Transparency and Promote Market Forces cit in Billing, available at http://www.justice.gov/ust/eo/public_affairs/articles/docs/2013/abi_201308.pdf. 256 The American Airlines case was filled with complex issues that required negotiation and resolution, including labor union agreements, airport agreements, aircraft leases, intercompany claims, a complicated merger agreement, and an antitrust lawsuit brought by the Department of Justice and the Texas Attorney General. See Glenn West & Stephen Youngman, American Airlines: From Chapter 11 to the World’s Largest Airline, Texas Lawbook (2014), available at http://texaslawbook.net/american-airlinesfrom-chapter-11-to-the-worlds-largest-airline/. 257 Detroit’s “historic” bankruptcy case is the largest municipal bankruptcy in the United States. Matthew Dolan, Cost of Detroit’s Historic Bankruptcy Reaches $126 Million, Wall St. J. (Sept. 12, 2014, 5:24 PM), http://online.wsj.com/articles/cost-of-detroitshistoric-bankruptcy-reach-126-million-1410557043. “Detroit’s bankruptcy case has been both complex with more than 100,000 creditors and fast-paced with a goal of exiting bankruptcy as soon as possible so the city can again be run by locally elected officials.” Id. The cost of the city’s bankruptcy case has reached, and is expected to surpass, $126 million, despite the presence of a fee examiner that was appointed by the bankruptcy court to monitor professionals’ fees. Id. However, city officials and a leading bankruptcy professor who studies professionals’ fees agree that the fees are reasonable and consistent with corporate bankruptcy costs, given the size of the case and the city’s plans to eliminate $7 billion in debt and reinvest $1.4 billion into blight removal and city services. Id. 258 Morath, supra note 206 (noting that Tribune’s chapter 11 case, “which began in December 2008, is one of the longest-running bankruptcies of the recent financial crisis as an ongoing fight between bondholders and the company has prevented Tribune from exiting Chapter 11 protection”). 259 Similarly, the Lehman Brothers bankruptcy case was viewed by a law professor as a “really complicated case” that was “really big and had some novel issues.” James O’Toole, Five Years Later, Lehman Bankruptcy Fees Hit $2.2 Billion, CNN Money (Sept. 13, 2013), http://money.cnn.com/2013/09/13/news/companies/lehman-bankruptcy-fees/. Judge Peck, the bankruptcy judge who presided over the case, observed that although the fee total was “a whopping number” in absolute terms, it was appropriate given the scale and complexity of the case. Id. 260 “Billing arrangements deal with the business of lawyering, but unlike other business contracts in the marketplace, lawyers cannot engage in unfettered arm’s-length transactions to negotiate with and provide services to their clients. . . . Lawyers’ duties affect, ex ante, the amount of the fees and the kind of arrangements available, the need to adjust fees as the conditions of the representation unfold, and the enforcement of fee contracts ex post. The duties owed by lawyers to their clients are founded on basic principles of fiduciary law: the duty of loyalty and fair dealing, and the duty of candor.” A.B.A. Comm. on Lawyer Bus. Ethics, Business and Ethics Implications of Alternative Billing Practices: Report on Alternative Billing Arrangements, 54 Bus. Law. 175, 190–201 (1998) (discussing various ethical issues that are raised by flat fees and contingency fees). 261 Model Rules of Prof ’l Conduct R. 1.2(a) (2013) (“[A] a lawyer shall abide by a client’s decisions concerning the objectives of representation and . . . shall consult with the client as to the means by which they are to be pursued.”); R. 1.4(a)(2) (“A lawyer shall . . . reasonably consult with the client about the means by which the client’s objectives are to be accomplished . . . .”). IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 70 of 402 Bankruptcy Institute standard of review under Bankruptcy Code section 330 that assesses whether the fees requested by a professional are “reasonable” for actual and “necessary” services rendered by such professional.262 Lawyers are also subject to a similar standard under their ethical code of conduct enforceable by their respective state bars.263 Some Commissioners believed that the Bankruptcy Code could do more to facilitate review of the results achieved by professionals in chapter 11 cases when determining the fees and expenses that should be awarded. For example, the court could grant a supplemental fee for extraordinary results or require disgorgement or reduce requested fees for actions that dissipated the value of the estate. Specifically, the Commissioners debated codifying directives that would require courts to (i) enhance fee awards for “exceptional efficiencies” or “exceptional results” and (ii) reduce lodestar compensation if the court finds that professionals’ actions led to otherwise avoidable and unacceptable inefficiencies or outcomes (without making professionals the “guarantors” of chapter 11 outcomes). Some Commissioners highlighted how such directives would be consistent with other decisions made by the Commission to encourage professionals to be more cost-effective in the representation of their clients, including the requirement that professionals for secured creditors and ad hoc committees demonstrate the reasonableness of their fees and expenses under section 330 of the Bankruptcy Code.264 These Commissioners felt that the Bankruptcy Code should induce professionals to strive for efficiency both in terms of the provision of professional services and the results for the estate. 16 1, 20 ber 2 vem The Commission considered the potential benefits to, and the potential unintended consequences n No ed o rch v of, such a review process. Although many Commissioners isupported the process in concept, they 63 a -353 .1 expressed concerns about the implementation 4 and the potential litigation invited by, such a , No of, rown B results-oriented fee review process.. These Commissioners were not persuaded that professionals hv ixset n Bllabel or the effects of hindsight bias in such a review process. Other i could avoid the “guarantor” cited Commissioners believed that structuring the review process to focus on administrative efficiencies fostered or impeded by professionals’ conduct could significantly mitigate these concerns. The Commissioners were not able to reach a consensus on a results-oriented fee review process because of these concerns, as well as the lack of objective data and academic literature evaluating the advantages and disadvantages of such a review process. The Commission also considered ex ante ways to control and mitigate professionals’ fees and expenses in chapter 11 cases. Reliance on the traditional lodestar method of billing and assessing professionals’ fees has arguably stifled innovation in fee structures and subjected debtors and unsecured creditors’ committees in bankruptcy to a one-size-fits-all fee structure that may be detrimental to bankruptcy estates in certain cases. The Commissioners generally agreed that professionals could develop more efficient ways to deliver cost-effective services to debtors and unsecured creditors’ committees. 262 Bankruptcy Code section 330(a) permits a court to award only “reasonable compensation for actual, necessary services rendered by the trustee, examiner, ombudsman, professional person, or attorney and by any paraprofessional person employed by any such person,” and permits only “reimbursement for actual, necessary expenses.” 11 U.S.C. § 330(a)(1). 263 Model Rules of Prof ’l Conduct R. 1.5(a) (2013) (“A lawyer shall not make an agreement for, charge, or collect an unreasonable fee or an unreasonable amount for expenses.”). “Every lawyer practicing in federal bankruptcy court holds at least one state bar card, and every state has an ethics rule regarding the duty of a lawyer to keep fees reasonable.” Rapoport, Rethinking Professional Fees in Chapter 11 Cases, supra note 212, at 291. 264 See Professionals and Compensation Issues. See also Wilbur Ross, Written Statement to the Commission (Apr. 19, 2013) (“The third problem is the individual large creditor or ad hoc group of such creditors who may or may not be on the official committee for that class but who in any event play a proactive individual role in the proceeding and ultimately seek reimbursement of professional fees based on the argument of ‘substantial contribution.”), available at Commission website, supra note 55.  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 71 of Chapter  Professionals could provide services on a fixed-fee or flat-rate basis; they could unbundle services and price different aspects of the case in different ways; or they could use discounted or alternative fee models.265 For example, counsel for the debtor in possession could charge a standard fixed rate for monthly monitoring and administrative matters in a case, a fixed rate for claims administration matters, and an hourly rate (subject to lodestar review) for plan negotiation and confirmation matters. Some Commissioners observed that alternative fee structures, such as a fixed-fee model, could overcompensate professionals in some cases, such as when the matter is less complex or is resolved more quickly than previously anticipated. Other Commissioners noted that the opposite is also possible when the estate would benefit because professionals underestimated the time and labor that a particular matter would demand.266 To compensate for this uncertainty, bankruptcy professionals could incorporate escalators or de-escalators in their original fee arrangements to address potential changes in either direction. As the Commissioners evaluated alternative fee structures, they recognized that the applicable standard of review was very important to the effectiveness of this reform. The standard of review had to permit variation from the traditional lodestar method, but require evidence from the professional that would allow the court to assess ex ante the potential advantages and disadvantages of the proposed alternative fee arrangement. The Commissioners did not believe that alternative 6 fee arrangements would be permissible in every scenario, and they er 21, 201 that courts could be believed b m guided (though not bound) by the types of alternative feenarrangements used in the market for Nove ed o chi comparable engagements and transactions. Indeed, rthev Commissioners viewed this reform as one 63 a -353 . 14 way to address the perception that bankruptcy professionals are not compensated in accordance , No rown B with market standards. The tCommission determined that the professional should bear the burden h v. xse n Bli of establishing theed i cit reasonableness of the arrangement, that the professional thoroughly reviewed the arrangement with the client (and the client consents to the arrangement), and that the arrangement is reasonably likely to be beneficial to the estate. The last of these factors — that the arrangement is reasonably likely to be beneficial to the estate — was fully vetted by the Commission. Indeed, the Commissioners contemplated that this factor would allow courts to prospectively consider the impact of proposed alternative fee arrangements. In assessing such arrangements under this factor, courts could consider, among other things: (i) how the arrangement might work during the case and the likely impact (both positive and negative) on the estate given various scenarios; (ii) the professionals’ justifications for the arrangement and any alternatives to the arrangement; (iii) the use of such arrangements in the market and whether the 265 See generally A.B.A. Comm. on Lawyer Bus. Ethics, supra note 260, at 182–87 (1998) (describing common types of alternative billing arrangements, including contingency-based fees (i.e., value billing or incentive billing), flat fees (based on tasks or percentages), and modification to hourly billing (e.g., caps, budgets, discounts, or phased billing)). See also Nancy B. Rapoport, The Case for Value Billing in Chapter 11, 7 J. Bus. & Tech. L. 117, 157–60 (2012) (encouraging law firms to consider alternative fee arrangements). 266 See Rapoport, Rethinking Professional Fees in Chapter 11 Cases, supra note 212, at 288 (“The advantage of a fixed fee is that it puts the onus of deciding the cost effectiveness of an activity on the person whose bottom line is affected: the professional. The disadvantage, although it’s not a major disadvantage, is that the size of the fixed fee could end up being woefully low for the amount of work that the professional needs to do, resulting in the professional having to finish up the job for free.”). “The rub with using a flat fee, of course, is that there’s a very real possibility that the flat fee will undercompensate the amount of work that the professional has to do. That risk, though, exists in non-bankruptcy cases as well, and as long as clients push for, and get, flat fees outside of bankruptcy, there’s no reason that courts can’t establish flat fees in bankruptcy cases.” Rapoport, The Case for Value Billing in Chapter 11, supra note 265, at 162. IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 72 of 402 Bankruptcy Institute proposed arrangement includes relevant and customary terms; and (iv) the overall potential benefit to the estate. The Commissioners underscored the need to have the court make these determinations at the beginning of the case or engagement, as applicable, to allow the professional, client, and estate to proceed with confidence in the bargain reached. This approach comports with market standards for alternative fee arrangements and promotes efficiency in their structure and use in chapter 11. Notably, section 328 currently allows alternative fee structures, and the Commission considered professionals’ and courts’ frequent reluctance to use or approve such structures.267 The Commissioners discussed the possible reasons underlying this reluctance. Many Commissioners believed that professionals and courts were reacting, at least in part, to the section 330 imperative, which prompts courts to review professionals’ fees and expenses using the lodestar method.268 Courts apply the lodestar method to determine — after the fact — the “reasonable” amount of attorney’s fees for a particular matter by multiplying the number of hours that should have reasonably been devoted to a particular matter by what the court deems to be a reasonable hourly rate. Applying the lodestar method ex post to review the amount that a professional has charged pursuant to an alternative fee structure, however, can skew incentives for professionals by creating uncertainty, and make the fee review process more labor-intensive than necessary for the courts.269 The Commissioners believed that, whatever the alternative fee agreement, the incentive for professionals to pursue such arrangements would depend, in part, on the willingness of courts 6 to enforce the original terms of the fee agreement, subject to ordinary client 201 1, defenses (including ber 2 em fraud or misrepresentation) and the current standard of review undervsection 328. The Commission n No ed o chiv agreed that the ex ante standard of review outlined aboverwould provide appropriate incentives and 63 a -353 . 14 a meaningful way for courts to assess alternative fee arrangements at the outset. On balance, the , No rown Commission determined thatxseth v. B alternative fee structures and more flexibility and innovation in fee Bli structures could generate isignificant cost savings for bankruptcy estates and could remove a barrier ed n cit for many companies that could not otherwise afford to pursue a chapter 11 reorganization. Finally, the Commission reviewed and evaluated recommended principles in other areas that, directly or indirectly, addressed professionals’ fees and expenses. For example, the principles discuss the standard of review that should apply to any fees and expenses of professionals for any secured creditor or ad hoc committee that requests payment of those amounts from the estate. The Commission agreed that such fees and expenses should be subject to the reasonableness standard of section 330 of the Bankruptcy Code.270 The principles also clarify the process for the debtor’s 267 Bankruptcy Code section 328(a) authorizes “the employment of a professional person under section 327 or 1103 of this title, as the case may be, on any reasonable terms and conditions of employment, including on a retainer, on an hourly basis, on a fixed or percentage fee basis, or on a contingent fee basis.” 11 U.S.C. § 328(a). However, section 328(a) also permits courts to deviate from these terms and conditions: “Notwithstanding such terms and conditions, the court may allow compensation different from the compensation provided under such terms and conditions after the conclusion of such employment, if such terms and conditions prove to have been improvident in light of developments not capable of being anticipated at the time of the fixing of such terms and conditions.” Id. 268 Section 330(a)(3) of the Bankruptcy Code prompts the court to “consider the nature, the extent, and the value of such services, taking into account all relevant factors, including — (A) the time spent on such services; (B) the rates charged for such services; . . . .” 11 U.S.C. § 330(a)(3). 269 One bankruptcy court, for example, approved retention of debtor’s counsel on the basis of a flat fee pursuant to section 328(a), which the court fixed at the outset at $1,200,000 plus costs. Rapoport, The Case for Value Billing in Chapter 11, supra note 265, at 161–62 (citing In re Kobra Props., 406 B.R. 396 (Bankr. E.D. Cal. 2009)). However, the court also reserved the right to adjust the fee downward based on a reexamination upon the occurrence of certain events or the deviation of the case from a traditional chapter 11 case. Id. Ultimately, the court awarded counsel fees that were indeed lower than the flat fee in the retention order. Id. 270 See Section IV.A.7, Professionals and Compensation Issues.  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 73 of Chapter  retention and payment of nonbankruptcy professionals.271 Furthermore, in reviewing and discussing the U.S. Trustee’s appointment of multiple committees in a case, the Commission observed several examples of courts authorizing committees to share professionals.272 B. Financing the Case 1. Adequate Protection Recommended Principles: The amount of adequate protection required under section 361 of the Bankruptcy Code to protect a secured creditor’s interest in a debtor’s property should be determined based on the foreclosure value of the secured creditor’s collateral. Nothing in this principle prohibits the trustee from seeking to sell a secured creditor’s collateral under section 363; in such a sale, the secured creditor’s allowed secured claim should be determined by the value actually realized from the sale of 16 its collateral under section 363. In the case of a chapter 11 rplan2contemplating a 1, 0 be 2 m reorganization of the debtor, the secured creditor’s Nove n allowed secured claim should ed o v be determined by the reorganization363 archof its collateral. For the definition of value i -35 1 defined for both the plan and the section 363x “reorganization value” (whicho.is 4 ,N rown .B sale contexts),ixseehSection VI.C.1, Creditors’ Rights to Reorganization Value and et v Bl s n Option Value. i Redemption cited For purposes of these principles, the term “foreclosure value” means the net value that a secured creditor would realize upon a hypothetical, commercially reasonable foreclosure sale of the secured creditor’s collateral under applicable nonbankruptcy law. In evaluating foreclosure value, a court should be able to consider a secured creditor’s ability to structure one or more sales, or otherwise exercise its rights, under applicable nonbankruptcy law, in a manner that maximizes the value of the collateral. In the case of a foreclosure sale in which the secured creditor would acquire the collateral through a credit bid, the foreclosure value should be based on the net cash value that a secured creditor would realize upon a hypothetical, commercially reasonable foreclosure sale, and not on the face amount of the debt used to acquire the property through the credit bid. The foreclosure value of a secured creditor’s collateral should be determined at the time of the request for, or agreement by the parties to provide, adequate protection under section 361. In granting adequate protection to a secured creditor under 271 See id. 272 See id. See also Rapoport, Rethinking Professional Fees in Chapter 11 Cases, supra note 212, at 290 (“[N]ot every fiduciary needs its own financial advisor. . . . Perhaps in some cases, one party (the DIP) could pay full freight for a financial advisor’s work, and other parties in interest could hire financial advisors for the limited purpose of reviewing the primary financial advisor’s work.”). IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 74 of 402 Bankruptcy Institute section 361(3), the court should be able to consider evidence that the net cash value that a secured creditor would realize upon a hypothetical sale of the secured creditor’s collateral under section 363 exceeds the collateral’s foreclosure value (a “value differential”). If the court makes a finding based on the evidence presented at the adequate protection hearing that a value differential exists, the court should be able to premise adequate protection under section 361, in whole or in part, on such value differential. In so doing, the court’s order also should provide that, if the court determines at a subsequent hearing that the secured creditor has presented sufficient evidence to warrant relief from the automatic stay with respect to the collateral, the trustee will conduct a sale of the collateral under section 363, unless the secured creditor elects otherwise. For purposes of this principle, the court may not enforce any waiver or agreement affecting a court’s ability to consider evidence and make determinations regarding the existence of a value differential or a secured creditor’s entitlement to relief from the automatic stay. This formulation of adequate protection complies with the original purpose of section 506(a), which provides that value “shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property, and in conjunction with any hearing on such disposition or use or on a plan affecting such creditor’s interest.” 11 U.S.C. § 506(a). Accordingly, the 016 foreclosure 2 r 21, value of a secured creditor’s collateral should not necessarilymbe determine the value ove on N other purposes in the of such collateral or the secured creditor’s allowedivclaim for ed arch 363 chapter 11 case. 5 14-3 . , No rown B A secured creditor etshould continue h v. ixs n Blthe foreclosure value section 507(b) ifor cited to receive priority treatment under of its collateral at the time of its request for adequate protection under section 361. To the extent existing law has been interpreted by courts to mean that the secured creditor must be “provided” with adequate protection in order to gain this benefit, such case law should be overturned by statute. It is sufficient that the secured creditor be deprived of the requested relief from the automatic stay to implicate the protections of section 507(b). A court should be able to approve a provision to cross-collateralize a secured creditor’s prepetition debt with the debtor’s or the estate’s postpetition property only for the purpose of providing adequate protection under section 361 and only to the extent that such cross-collateralization covers any decrease in the value of the secured creditor’s collateral as of the petition date. The court should not approve any proposed adequate protection under section 361 that grants a lien on, or any direct or indirect interest in (including through a superpriority claim), the estate’s avoidance actions or the proceeds of such actions under chapter 5 of the Bankruptcy Code. Nevertheless, this prohibition should not limit the proceeds available to satisfy a prepetition secured creditor’s claim arising solely under section 507(b).  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 75 of Chapter  Adequate Protection: Background The filing of a chapter 11 case stays the enforcement of many creditors’ actions against the debtor, including the collection and foreclosure actions of secured creditors. Moreover, following a filing, the debtor in possession273 may continue to use its property, including any cash collateral, to operate its business and to facilitate its reorganization efforts. Although the debtor’s right to the automatic stay and the continued use of its property ultimately benefit all stakeholders, the debtor’s exercise of these rights directly affects the rights of secured creditors holding interests in the debtor’s property. On the other hand, allowing a secured creditor to foreclose immediately on the debtor’s property or to demand payment in full from the debtor would crater the debtor’s reorganization efforts at the outset; such a provision would essentially turn chapter 11 into a liquidation statute. The concept of adequate protection is intended in part to balance the prepetition rights of secured creditors with the postpetition rehabilitative purposes of the Bankruptcy Code. If a debtor seeks to use cash collateral or prime a prepetition secured creditors’ interests as part of, or pursuant to, a postpetition financing arrangement, or if the secured creditor requests relief from the automatic stay that is denied, section 361 of the Bankruptcy Code requires the debtor to provide the secured creditor with adequate protection of its interest in property. The Bankruptcy Code does not define the term “adequate protection,” but courts generally have interpreted it to mean compensation to secured creditors for any depreciation or diminution in the value of the secured creditor’s interest caused by the debtor in possession’s use of collateral during the chapter 21, 2016 274 The extent of this 11 case. er emb protection turns on the court’s determination of the “value” n Nov secured creditors’ interest in the of the do chive debtor’s interest in property.275 r 63 a 53 14-3 No. wn, Section 361 offers three nonexclusive means for providing a secured creditor with adequate . Bro eth v xs protection of its securedliinterest: (i) cash payments; (ii) a replacement lien; or (iii) other protection in B cited that will result in the realization of the indubitable equivalent of the secured creditor’s interest in the property.276 The language of section 361 is permissive and suggests that other means for providing adequate protection may also exist. Nevertheless, courts and debtors in possession mostly rely on these three articulated means, with the types of adequate protection that would satisfy the third option — providing the indubitable equivalent of the secured creditor’s interest — largely determined on a case-by-case basis.277 In addition, issues of valuation often are at the heart of the adequate protection determination. Courts have used a variety of valuation standards in assessing the sufficiency of adequate protection under section 361. These standards have included liquidation value, going concern value, and various market valuations.278 Section 361 does not specify the appropriate valuation standard. In the context 273 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. 274 See, e.g., United Sav. Ass’n of Tex. v. Timbers of Inwood Forest Assocs., Ltd, 484 U.S. 365 (1988); In re Delta Res., Inc., 54 F.3d 722, 730 (11th Cir. 1995), cert. denied, 516 U.S. 980 (1995); In re Cason, 190 B.R. 917, 928 (Bankr. N.D. Ala. 1995). 275 See, e.g., Wright v. Union Cent. Life Ins. Co., 311 U.S. 273 (1940). 276 11 U.S.C. § 361(1), (2), (3). 277 The legislative history of section 361(3) suggests that “abandonment of the collateral to the creditor would clearly satisfy indubitable equivalence, as would a lien on similar collateral . . . Unsecured notes as to the secured claim or equity securities of the debtor would not be the indubitable equivalent.” H.R. Rep. No. 95-595 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6544 (statement of Senator Dennis DeConcini). 278 See, e.g., Christopher S. Sontchi, Valuation Methodologies: A Judge’s View, 20 Am. Bankr. Inst. L. Rev. 1, 2 & n. 5 (2012) (“Broadly speaking, a firm, its assets or its equity can be valued in one of four ways: (i) asset-based valuation where one estimates the value IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 76 of 402 Bankruptcy Institute of determining the value of a secured creditor’s allowed claim, section  506(a) of the Bankruptcy Code provides that “[s]uch value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property, and in conjunction with any hearing on such disposition or use or on a plan affecting such creditor’s interest.”279 Adequate Protection: Recommendations and Findings Adequate protection is a critical determination made early in a chapter 11 case that can affect the ultimate outcome of the debtor’s reorganization and creditor recoveries. It serves both to protect the particular interests of secured creditors and to facilitate the overall objectives of the estate. By permitting the use of collateral subject to the provision of adequate protection, the debtor in possession can put its property to work for the estate and focus on implementing an effective reorganization strategy. The Commissioners engaged in a detailed review of the conceptual underpinnings and purpose of adequate protection under section 361 of the Bankruptcy Code. Although the Commissioners generally agreed on the purpose and importance of the adequate protection concept, they heavily debated and vetted the various approaches to providing adequate protection to secured creditors. The Commissioners discussed the potentially competing needs early in the case from the perspectives of the debtor in possession and the secured creditors. To illustrate, debtors in possession need to use 16 1, 20 their property — at least such property that is necessary to their reorganization efforts — and they ber 2 em need liquidity typically through postpetition financing and theon Nov cash collateral. Meanwhile, use of ed hiv secured creditors need assurance that the debtor’s-35363 arc reorganization efforts will not adversely affect the . 14 value of their interests in the debtor’s property. , No rown B h v. xset n Bli i ited Commissioners cdiscussed the kinds The of prepetition liens and security interests often placed on a debtor’s property and the impact of a “blanket lien” that encumbers all of the debtor’s assets under applicable state law.280 The Commissioners acknowledged the increasing use of blanket liens in secured financing transactions and discussed the potential value of these liens to the extent they reduce the cost of capital and provide prepetition liquidity to the debtor. The Commissioners also recognized the general proposition, which is reflected in the legislative history of section 361, that the Bankruptcy Code should provide secured creditors with the value of their prepetition bargain.281 To that end, the Commission considered the various ways of providing secured creditors with the value of their prepetition bargain in the context of adequate protection. of a firm by determining the current value of its assets, (ii) discounted cash flow or ‘DCF’ valuation where one discounts cash flows to arrive at a value of the firm or its equity, (iii) relative valuation approaches, which include the ‘comparable company analysis’ and the ‘comparable transaction analysis’ that base value on how comparable assets are priced, and (iv) option pricing that uses contingent claim valuation.”) (citing cases that considered these various methodologies). 279 11 U.S.C. § 506(a). 280 See, e.g., Kenneth M. Ayotte & Edward R. Morrison, Creditor Control and Conflict in Chapter 11, 1 J. Legal Analysis 511, 523 (2009) (reviewing prepetition financing arrangements and observing that approximately 97 percent of prepetition financing facilities are secured by liens akin to blanket liens). See also Juliet M. Moringiello, When Does Some Federal Interest Require a Different Result?: An Essay on the Use and Misuse of Butner v. United States, 2015 Ill. L. Rev. __, at *33 (forthcoming 2015) (“These blanket liens, coupled with the expanded definition of proceeds as a result of the 2001 amendments to Article 9 of the Uniform Commercial Code, leave no unencumbered assets for unsecured creditors. Some have argued that the 2001 amendments to Article 9 impermissibly amend bankruptcy law.”), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2445584. 281 H.R. Rep. No. 95-595 (1977) (“Secured creditors should not be deprived of the benefit of their bargain. . . . [T]he purpose of the section is to insure that the secured creditor receives the value for which he bargained.”).  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 77 of Chapter  Given that adequate protection turns on the value attributable to the secured creditor’s interest in a debtor’s interest in property, the Commission discussed the various methods of determining such value, explored situations in which different methods may apply, and considered the consequences to the estate and secured creditors of applying these methods. First, the Commission evaluated the potential use of “liquidation value,” which is typically applied in the event of a forced or orderly liquidation. The use of a forced liquidation standard may produce a lower valuation of the property interest, facilitating the debtor’s use of the property, but potentially reducing the secured creditor’s recoveries in the case. Second, the Commission evaluated the potential use of “going concern value,” which is used to evaluate the enterprise value of a debtor with an assembled workforce and operating business.282 The use of a going concern valuation may produce a higher valuation of the property interest, providing greater protection of the secured creditor’s interest in the debtor’s property, but perhaps reducing significantly the debtor’s financing and reorganization options. A going concern valuation also may provide more protection than necessary in those cases when the secured creditor does not have an interest in the entirety of the debtor’s assets.283 Ultimately, however, the Commission agreed that, for purposes of determining adequate protection under section 361, a secured creditor’s interest in the debtor’s property should be determined based on the “foreclosure value” of such interest, instead of more commonly used valuation standards such as liquidation value and going concern value. The foreclosure standard is meant to capture the value of the secured creditor’s interest as of the petition date (i.e., the value that a secured creditor’s state 16 law foreclosure efforts would produce if the automatic stay were lifted 21, the bankruptcy case had or 20 ber vem not been filed).284 The foreclosure value should be determinedocase by case based on the evidence nN ed o rchiv presented at the adequate protection hearing, 3taking into account the realities of the applicable 63 a -35 4 foreclosure markets and legal schemes.No. 1 wn, cited h v. xset n Bli i Bro 282 See generally Robert Rhee, Essential Concepts of Business for Lawyers 155–59 (2012) (explaining different ways to value a company). 283 A secured creditor may have interests in only certain of the debtor’s assets or something less than the entirety of the enterprise. See, e.g., Melissa B. Jacoby & Edward J. Janger, Ice Cube Bonds: Allocating the Price of Process in Chapter 11 Bankruptcy, 123 Yale L.J. 862, 922–23 (2013) (“Yet, not all property can be encumbered by a security interest as a legal or practical matter. Whatever the intentions of the parties, the so-called blanket lien is likely to have gaps.”). See also Edward Janger, The Logic and Limits of Liens, 2015 Ill. L. Rev. __, at *5–6 (forthcoming 2015) (noting that so-called blanket liens under Article 9 of the Uniform Commercial Code may exclude tort claims, real estate, recoupment and setoff claims, insurance claims, and others); Michelle M. Harner, The Value of Soft Assets in Corporate Reorganizations, 2015 Ill. L. Rev. __, at *24 (forthcoming 2015) (“If a company holds a going concern surplus … some portion of that value is attributable to soft variables and, if realized postpetition, is not (or should not be) subject to a prepetition security interest. … [There is] support for this position under the Bankruptcy Code.”), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2444699. But see First Report of the Commercial Fin. Ass’n to the ABI Comm’n to Study the Reform of Chapter 11: Field Hearing at Commercial Fin. Ass’n Annual Meeting, at 4–5 (Nov. 15, 2012) (“While some commentators have advocated limiting a secured creditor’s interest to ‘liquidation value’ while preserving incremental ‘going-concern surplus’ for the benefit of others, CFA submits that prepetition lending expectations should be preserved. For example, with an increasingly large segment of the secured lending market dedicated ‘cash-flow lending’ predicated upon the present value of anticipated future income streams or cash-flows based upon a multiple of EBITDA, when those proceeds are realized upon a sale (whether voluntary or involuntary), the net proceeds of sale should be allocable to the secured party. On the other hand, consistent with pre-bankruptcy expectations, the secured creditor should also be required to bear the reasonable costs and expenses incurred in connection with the preservation and disposition of the collateral (a concept presently addressed by §506(c) of the Code). Accordingly, CFA believes that the Commission should consider codifying the principal that the secured creditor’s interest includes the realizable value of the collateral including going-concern value.”), available at Commission website, supra note 55. 284 Under the parties’ prepetition agreements, the secured creditor generally is entitled to foreclose on its collateral upon the debtor’s default. The chapter 11 case and the automatic stay prevent a secured creditor from being able to exercise its state law foreclosure rights. The foreclosure valuation standard for adequate protection purposes preserves the value of the secured creditor’s interest under its prepetition bargain with the debtor. Edward Janger, The Logic and Limits of Liens, supra note 283 (arguing that the lienholder should only be entitled to the value it could have received if it had pursued state law remedies) (emphasis added). As discussed below, however, the Commission determined that for distribution purposes in the case, a secured creditor should be entitled to receive the reorganization value of its collateral. IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 78 of 402 Bankruptcy Institute Notably, the Commission’s decision to use foreclosure value is an integral part of the delicate balance the Commission struck between the rights of secured creditors, on the one hand, and the reorganizational objectives of the estate, on the other hand. Specifically, the Commission agreed that the foreclosure value of an interest should be used early in the case when determining adequate protection issues, but that the secured creditor should be entitled to receive the reorganization value of its interest in the debtor’s property through the claims allowance and distribution process later in the case.285 In addition, the Commission agreed that a secured creditor should receive additional assurances if the court permits the debtor to provide adequate protection by showing a sufficient equity cushion in the property — i.e., a sufficient differential between the foreclosure value and the section 363x sale value of the secured creditor’s interest in the debtor’s property. In this instance, the Commission determined that the court should have the ability to provide in the adequate protection order that, if the debtor in possession’s reorganization efforts fail, or if the court subsequently finds cause that would support lifting the automatic stay with respect to the secured creditor’s collateral, the debtor in possession or the chapter 11 trustee must sell the secured creditor’s collateral under section 363 of the Bankruptcy Code, unless the secured creditor elects otherwise. This compromise reflects the reality that, if adequate protection is provided based on the reorganization value of the collateral, the secured creditor should have a means of realizing such reorganization value if adequate protection is subsequently proven to insufficiently protect the secured creditor’s interests. 16 1 20 Although the Commissioners discussed potential ways that secured creditors, could try to impede ber 2 vem the debtor’s reorganization efforts by triggering their need for additional assurance, the Commission n No ed o iv ultimately determined that the court could monitor5such rch 63 aconduct by enforcing its orders. Moreover, -3 3 . 4 the Commission concluded that such conduct 1 rare and likely counterproductive for the secured , No is rown B hv creditor, which would otherwise tbe .entitled to receive the reorganization value (which is defined in xse n Bli i the sale context as the iactual sale price) of its collateral upon the confirmation of the debtor’s plan or c ted the approval of a section 363x sale. The Commissioners discussed the general uses for, and the current split in the case law regarding the permissibility of, cross-collateralization. They recognized that, on the one hand, crosscollateralization may serve valid interests that would benefit the estate, but on the other hand, it may also result in overreaching and an impermissible improvement of a prepetition lender’s position. The Commission ultimately decided that debtors in possession should be able to use crosscollateralization to provide adequate protection to prepetition secured creditors, but only to the extent that such cross-collateralization would protect against the decrease in the value of the secured creditor’s interest in the debtor’s property. The Commission also considered whether a debtor in possession should be able to grant a replacement lien in its chapter 5 avoidance actions or the proceeds of such actions to provide adequate protection to a secured creditor under section 361.286 The Commission reviewed the original policies underlying the trustee’s avoiding powers under chapter 5 of the Bankruptcy Code, including allowing the trustee to avoid prepetition transfers that preferred certain unsecured creditors and reallocating the 285 The term “reorganization value” and its role in the claims distribution process is discussed below. See Section VI.C.1, Creditors’ Rights to Reorganization Value and Redemption Option Value. 286 For a discussion of the treatment of liens in chapter 5 avoidance actions in the postpetition financing context, see Section V.C, Avoiding Powers.  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 79 of Chapter  recovered value from such avoidance actions more fairly through the bankruptcy claim distribution process. The Commissioners also observed that chapter 5 avoidance actions and recoveries often are among the few unencumbered assets of a debtor’s estate and therefore may be the only resource available to repay unsecured claims. On balance, the Commission determined that the debtor in possession should not be permitted to use chapter 5 avoidance actions or recoveries to provide adequate protection to secured creditors. The only exception to this general rule is that if the adequate protection granted to a secured creditor is determined to be insufficient, then such secured creditor should be allowed to receive recoveries from avoidance actions through the creditor’s superpriority claim under section 507(b) of the Bankruptcy Code. 2. Terms of Postpetition Financing Recommended Principles: A court should not approve any proposed postpetition financing under section 364 of the Bankruptcy Code that contains a provision to roll up prepetition debt into the postpetition facility or to pay down prepetition debt in part or in full with proceeds of the postpetition facility. This provision should not apply to postpetition financing, including a facility that refinances in part or in full prepetition debt, to the extent that — 016 21, 2 berwho do not directly o the postpetition facility (a) is provided by Novem lenders n ed o or indirectly through their affiliates hiv prepetition debt affected by the rc hold 63 a -353 facility or (b) repays No. 14 the prepetition facility in cash, extends substantial , rown B new credit ttovthe debtor, and provides more financing on better terms than h . xse n Bli i alternative facilities offered to the debtor; and cited o the court finds that the proposed postpetition financing is in the best interests of the estate. A court should not approve any proposed postpetition financing under section 364 that grants a lien on, or any interest in (including through a superpriority claim), the estate’s avoidance actions or the proceeds of such actions under chapter 5 of the Bankruptcy Code. Subject to a 60-day restriction on milestones, benchmarks, and similar provisions (see Section IV.C.1, Timing of Approval of Certain Postpetition Financing Provisions), a court should be able to approve, in a final order, permissible extraordinary financing provisions in connection with any proposed postpetition financing under section 364. For the definition of “permissible extraordinary financing provisions,” see Section IV.C.1, Timing of Approval of Certain Postpetition Financing Provisions. Any prepetition contractual prohibition on subordinated prepetition junior secured creditors offering or providing postpetition financing to the debtor should not be enforced in the chapter 11 case, provided that: (i) any such subordinated prepetition junior secured creditors should not be permitted to prime the perfected security interests of the prepetition senior secured creditors with the postpetition financing IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 80 of 402 Bankruptcy Institute facility; and (ii) if the court approves the postpetition financing facility offered by the subordinated prepetition junior secured creditors, the prepetition senior secured creditors should have the option to match the terms of, and to provide the financing facility in lieu of, the subordinated junior secured creditors within a reasonable time as specified in the court’s interim order approving the postpetition financing. These provisions would render unenforceable any contractual damages provisions that would otherwise allow prepetition senior secured creditors to recover damages for breach of contract against subordinated prepetition junior secured creditors under nonbankruptcy law based on the provision of postpetition financing. Sections 364 and 510 should be amended accordingly. Terms of Postpetition Financing: Background A debtor in possession287 needs liquidity to operate its business during the chapter 11 case and to finance its reorganization efforts. Some debtors in possession may be able to use cash collateral and its ongoing revenue streams for these purposes, but many debtors need a new, postpetition financing facility to achieve their postpetition objectives.288 Section 364 of the Bankruptcy Code generally governs a debtor in possession’s requests to obtain postpetition financing. 6 , 201 Section 364 is structured in part to incentivize lenders to extend credit vember 21 to a company in bankruptcy.289 No on Currently, this section permits a debtor in possession to hobtain postpetition financing on either ived arc 5 63 an unsecured basis or, after notice and a hearing,3in exchange for administrative priority.290 In 14-3 No. w , addition, upon making certain showings,na debtor may be authorized to incur postpetition debt as . Bro eth v a secured claim in unencumbered property, a junior secured ix a superpriority administrative s in Bl claim, cited claim (by priming prepetition senior secured creditors).291 The last of these claim, or a senior secured incentives is the most difficult for debtors in possession to obtain because section 364(d) requires the debtor in possession to show that no other financing is available and that the interests of the prepetition secured creditors that would be primed by the new facility are adequately protected.292 Because a debtor in possession may not be able to prime its prepetition secured lenders under the current standards for adequate protection, a debtor in possession often tries to negotiate a postpetition financing facility with its prepetition secured lenders. Such postpetition facilities may include crosscollateralization or roll-up provisions that provide additional protection to the prepetition lenders on their prepetition claims against the estate. Whether a court should approve cross-collateralization 287 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. 288 Prepetition loan agreements are considered “financial accommodations” that the trustee cannot elect to assume (and thereby require performance) under section 365 of the Bankruptcy Code. “[Section 365(c)] permits the trustee to continue to use and pay for property already advanced, but is not designed to permit the trustee to demand new loans or additional transfers of property under lease commitments.” H.R. Rep. 95-595, 1978 U.S.C.C.A.N. 5963, 6304. Accordingly, the debtor in possession needs to negotiate a new financing arrangement, which may be provided by new lenders or some or all of its prepetition lenders. 289 See, e.g., Paul M. Baiser & David G. Epstein, Postpetition Lending Under Section 364: Issues Regarding the Gap Period and Financing for Prepackaged Plans, 27 Wake Forest L. Rev. 103, 103–04 (1992) (“To counter the understandable reluctance of financial institutions to lend to Chapter 11 debtors, section 364 of the [Bankruptcy] Code provides incentives to lenders to provide financing to borrowers who are the subject of bankruptcy cases.”) (citations omitted). 290 11 U.S.C. § 364(a) (unsecured credit); id. § 364(b) (administrative claim). 291 Id. § 364(c) (superpriority administrative claim, junior lien, or lien on unencumbered property); id. § 364(d) (priming lien). 292 Id. § 364(d)(1) (requirements for priming lien); id. § 364(d)(2) (burden on the trustee/debtor in possession).  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 81 of Chapter  and roll-up provisions is subject to debate and frequently depends on the jurisdiction in which the chapter 11 case is pending.293 In addition, the debtor may be limited to negotiating its postpetition financing facility with only its prepetition senior secured creditors if the debtor’s prepetition junior secured creditors are prohibited from extending postpetition financing to the debtor pursuant to a prepetition intercreditor or subordination agreement.294 Terms of Postpetition Financing: Recommendations and Findings The Commissioners analyzed a variety of issues relating to debtor in possession financing. They considered, among other things, the impact of the terms of a postpetition facility on the chapter 11 case and the debtor’s stakeholders, as well as the importance of a robust financing market to the chapter 11 process. The Commissioners discussed the kinds of provisions that protect the interests of postpetition lenders and encourage the extension of credit to chapter 11 debtors. Some Commissioners suggested that lenders do not need additional incentives because postpetition financing has historically been not only safe, but also very profitable.295 Other Commissioners challenged this assumption, noting the tightening of the postpetition credit market during the 2008 financial crisis.296 The Commission reviewed extensive materials on postpetition financing markets, terms, and impact, including a detailed report from the advisory committee and data compiled by the Loan 6 , 201 r 21 mbe Nove on ived arch 293 For cases allowing cross-collateralization, see In re Ames 5363 Stores, Inc., 115 B.R. 34, 39–40 (Bankr. S.D.N.Y. 1990); In re FCX, 4-3Dep’t Inc., 54 B.R. 833, 840 (Bankr. E.D.N.C. 1985);No. 1Vanguard Diversified, Inc., 31 B.R. 364, 366 (Bankr. E.D.N.Y. 1983); In re n, In reE.D.N.Y. 1982). For cases disallowing cross-collateralization, see Shapiro v. w Gen. Oil Distrib., Inc., 20 B.R. 873,v875–76 (Bankr. . Bro Saybrook Mfg. Co., Inc. (Inlixseth re Saybrook Mfg. Co., Inc.), 963 F.2d 1490, 1494–96 (11th Cir. 1992) (cross-collateralization is per se impermissible); Intred in B Corp., 596 F.2d 1092 (2d Cir. 1979); In re Fontainebleau Las Vegas Holdings, LLC, 434 B.R. 716 (S.D. Texlon ci e Fla. 2010). For cases allowing roll-ups in certain circumstances, see In re Uno Rest. Holdings Corp., Ch. 11 Case No. 10-10209 (MG) (Bankr. S.D.N.Y. Jan. 20, 2010); In re Foamex Int’l Inc., Ch. 11 Case No. 09-10560 (KJC) (Bankr. D. Del. Feb. 18, 2009); In re Aleris Int’l, Inc., Ch. 11 Case No. 09-10478 (BLS) (Bankr. D. Del. Feb. 12, 2009); In re Tronox Inc., Ch. 11 Case No. 09-10156 (ALG) (Bankr. S.D.N.Y. Jan. 12, 2009); In re Lyondell Chem. Co., Ch. 11 Case No. 09-10023 (REG) (Bankr. S.D.N.Y. Jan. 6, 2009). Notably, the permissibility of these and other provisions in a postpetition facility are governed by section 364 of the Bankruptcy Code and are generally protected on appeal and subject only to reversal if lack of good faith is established. See 11 U.S.C. § 364(e). 294 For a general discussion of issues in intercreditor agreements, see Mark N. Berman & David Lee, The Enforceability in Bankruptcy Proceedings of Waiver and Assignment of Rights Clauses Within Intercreditor or Subordination Agreements, 20 Norton J. Bankr. L. & Prac., Art. 1 (2011). 295 See, e.g., Marshall S. Hueber, Debtor-in-Possession Financing, RMA J., Apr. 2005, at 33 (“[DIP lending] can be an eminently logical and profitable endeavor. Indeed, because of the many lender protections enshrined in the U.S. Bankruptcy Code to induce DIP lending, the safest loans in a troubled industry may well be those made to bankruptcy debtors.”); David A. Skeel, Jr., The Past, Present and Future of Debtor-in-Possession Financing, 25 Cardozo L. Rev. 1905, 1906 (2004) (“[T]he generous terms offered to DIP financers have encouraged lenders to make loans to cash-starved debtors, and that these lenders have used their leverage to fill a governance vacuum that was created by the enactment of the 1978 Code.”); Joseph V. Rizzi, Opportunities in DIP Financing, Bankers Mag., July/Aug. 1991, at 49 (“New postpetition lenders can earn attractive returns from relatively secure assets and participate in a growing market.”). See also Written Statement of Kathryn Coleman, Attorney at Hughes Hubbard & Reed, LLP: TMA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 1–6 (Nov. 3, 2012) (noting that DIP lending is profitable and safe but is no longer being used to help rehabilitate the debtor and arguing that some roll-up facilities can have a significant negative effect on a debtor’s ability to exit chapter 11), available at Commission website, supra note 55 296 See, e.g., Kenneth Ayotte & David A. Skeel, Jr., Bankruptcy or Bailouts?, 35 Iowa J. Corp. L. 469, 488 (“A system-wide lending failure like the recent credit crisis raises the question whether private sources of bankruptcy financing will always be available. Through much of 2008, few companies that filed for bankruptcy were able to obtain financing.”); Robert H. Barnett & Brian J. Grant, Credit Crisis Puts Focus on Out-of-Court Restructurings, J. Corp. Renewal, June 14, 2010 (“DIP financing sources seized up at the onset of the credit crunch and banking crisis in 2008. Several large institutions in the third quarter of that year dramatically tightened new DIP lending; Lehman Brothers filed for bankruptcy in September of 2008, and Merrill Lynch and Wachovia, two other top players in the market, were sold in last-minute distressed deals to Bank of America and Wells Fargo, respectively. As credit vanished throughout the financial system, other DIP lenders followed suit. . . . [T]he number of active DIP lenders dropped from more than 30 at the beginning of 2008 to only five or six by the end of the year. Aside from some high-profile deals in which lenders pulled together to support large companies (such as Lyondell Chemical Co.’s $8 billion Postpetition financing facility, which came with a 13 percent interest rate and a 7 percent fee), DIP financing remained scarce in 2009, forcing companies either to restructure by other means or to move straight to liquidation.”), available at http://www.turnaround.org/ Publications/Articles.aspx?objectID=13015. IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 82 of 402 Bankruptcy Institute Syndications and Trading Association (the “LSTA”).297 The LSTA’s data suggest that the majority of debtors that enter into postpetition financing agreements do not liquidate, but rather reorganize.298 Specifically, based on the Commission’s review of the LSTA data: (i) 69 percent of firms that had postpetition financing reorganized, whereas 52 percent of firms that did not have postpetition financing reorganized; (ii) 38 percent of firms without postpetition financing liquidated, whereas 23 percent of firms with postpetition financing liquidated; (iii) 16 percent of firms that had postpetition financing were eventually sold pursuant to a section 363 sale, whereas only 8 percent of firms that did not have postpetition financing were sold pursuant to a section 363 sale; and (iv) any relationship between postpetition financing agreements and chapter 7 liquidations is inconclusive.299 In addition, the Commissioners evaluated testimony that (i) markets for secured leveraged debt, especially with the benefits of senior secured status, and high-yield bonds are large and critical to economic growth; (ii) secondary trading markets are deep and liquid even during times of great distress; (iii) assets in bankruptcy are liquid and volatile, but can appreciate and increase the enterprise value or provide a less certain path toward profitability; and (iv)  debtor in possession financing provides much needed liquidity to distressed companies at market rates based on the risk profile of the particular debtor.300 They also considered testimony that postpetition financing agreements include tighter covenants and milestones often designed to facilitate a loan-to-own 297 The LSTA dataset is found at Exhibit B, with related materials at Exhibits A and C, to Mr. Shapiro’s supplemental testimony. 16 Supplemental Written Statement of Mark Shapiro: ABI Winter Leadership Conference Field Hearing 20 1, Before the ABI Comm’n to ber 2 supra note 55. See generally Study the Reform of Chapter 11, at Exhibits A, B, C (Nov. 30, 2012), available at Commission website, ovem supra note 66 and accompanying text (generally discussing limitations of chapter n N d eitso 11 empirical studies). LSTA’s dataset focuses 298 The Commission appreciated the LSTA’s contribution to the field hearings hiv arc and work on this dataset. The on postpetition financing facilities in large chapter 11 cases-35363 since 2006. It is an extension of the UCLA-LoPucki Bankruptcy o. 4 Research Database, and it records information on chapter 1 cases filed since 2006 with reported assets of between $500 million n, N 11 ro not and $10 billion, with the addition of fivevcases w in the UCLA-LoPucki Bankruptcy Research Database. The LSTA dataset .B contains 167 observations, with eacheth observation representing a separate postpetition financing facility (so one company may Blixs n had more than one facility or filed more than one chapter 11 case). Of the 167 observations, 157 have multiple observationsd iit ite if of the observations arec unique cases, reflecting the fact that some firms have more than one DIP facility per case. Of these, 149 are unique companies, reflecting the fact that 8 firms have filed for bankruptcy more than once in the dataset. Supplemental Written Statement of Mark Shapiro: ABI Winter Leadership Conference Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at Exhibit C (Nov. 30, 2012), available at Commission website, supra note 55. See generally supra note 66 and accompanying text (generally discussing limitations of chapter 11 empirical studies). 299 These analyses were based on the data in Exhibit B to Mr. Shapiro’s supplemental testimony. Supplemental Written Statement of Mark Shapiro: ABI Winter Leadership Conference Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at Exhibit B (Nov. 30, 2012), available at Commission website, supra note 55. In performing these analyses, cases with multiple postpetition financing observations and the cases added to the dataset from outside of the UCLA-LoPucki Bankruptcy Research Database (they did not meet the criteria of the original database and could skew observations; notably, the percentages do not vary greatly if all observations are included) were excluded. Accordingly, these data are based on 157 cases: 91 of these cases had a postpetition financing facility; 69 percent (or 63 out of 91) of cases reorganized. This means 31 percent (or 28 out of 91) of cases did not reorganize. Conversely, 42 of the cases did not have DIP Financing; 52 percent (or 22 out of 42) of cases reorganized; 48 percent (or 20 out of 42) of cases did not reorganize. It is important to note that 24 of these cases were missing data. Also, these observations are limited by the qualifications typically associated with empirical analyses of chapter 11 cases, as well as the fact that the dataset was missing some data and focused only on large, public company cases. Nevertheless, the data are still very informative, and align with general perceptions that many distressed companies need some form of postpetition financing to use chapter 11 effectively. Id. See generally supra note 66 and accompanying text (generally discussing limitations of chapter 11 empirical studies). 300 Written Statement of Ted Basta on behalf of LSTA: LSTA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (Oct. 17, 2012) (describing leveraged loan and high yield markets and noting resulting liquidity to distressed companies), available at Commission website, supra note 55; Supplemental Written Statement of Mark Shapiro: ABI Winter Leadership Conference Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 2–3 (Nov. 30, 2012) (explaining dynamics of postpetition financing negotiations and detailing components of, and factors considered in pricing, such financing), , available at Commission website, supra note 55. “The DIP lending market provides a complex and challenging arena for lenders. Not only must they engage in all analyses that are attendant to a more typical loan to a non-distressed commercial borrower, but they also must understand the legal and financial framework that encompasses a potential borrower in a Chapter 11 case, including the impact of Chapter 11 on the Debtor’s business.” Id. See also Edward I. Altman, The Role of Distressed Debt Markets, Hedge Funds and Recent Trends in Bankruptcy on the Outcomes of Chapter 11 Reorganizations, 22  Am. Bankr. Inst. L. Rev. 75, 84 (2014) (observing that the size and sophistication of the distressed debt market has “provided the incentive for a special breed of investors, experienced in distressed investing, to attract capital and . . . provide a potential outlet for original investors to monetize their troubled assets. . . . This liquidity is crucial to those [] investors who do not have the resources, expertise or desire to hold their claims until the resolution of the reorganization” and impacts other financing markets”).  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 83 of Chapter  transaction for the lender or a sale of the assets in the chapter 11 case.301 In reviewing the testimony, the Commissioners debated the advantages and disadvantages of postpetition financing terms.302 As a general matter, the Commissioners recognized the need for a robust, competitive postpetition financing market and the value it provides to distressed companies. They also appreciated the potential impact that any suggested reforms might have on that market; they aimed to encourage a competitive postpetition financing market that provided debtors with access to necessary financing on terms that would facilitate their restructuring efforts — an outcome that benefited all stakeholders. Accordingly, the Commissioners carefully analyzed the materials discussing, and the implications of issues involving postpetition financing. The Commissioners further acknowledged that the focus of section 364 should be on permitting parties to negotiate market agreements that do not overreach or negatively impact the rights of other stakeholders beyond the terms necessary to obtain postpetition credit in a particular case. To strike this balance, the Commissioners first evaluated the use of roll-up and cross-collateralization provisions in postpetition facilities. The Commissioners discussed the different kinds of rollup provisions and their different justifications, specifically comparing provisions in postpetition facilities provided by a prepetition lender with provisions in postpetition facilities provided by a completely new lender.303 The Commissioners generally agreed that the greatest opportunity for abuse in the context of roll-up provisions occurs when a prepetition lender provides a postpetition 16 1, 20 ber 2 vem n No 301 See, e.g., Written Statement of Kathryn Coleman, Attorney at Hughes Hubbard & Reed, LLP: TMA Field Hearing Before the ABI ed o of where the debtor gets its DIP financing, the game Comm’n to Study the Reform of Chapter 11, at 4–5 (Nov. 3, 2012) archiv (“Regardless has dramatically changed. Lenders providing postpetition 363 -35financing no longer do so in order to make good returns with assured 4 repayment, or protect their prepetition positions o. 1 , N by getting collateral for previously unsecured loans. Instead, they often do so in rown order to take control of the debtor, through covenants, deadlines, and default provisions. And these are no mere financial tests to B h v. ensure the safety of the lender’serepayment.”), available at Commission website, supra note 55; Written Statement of Holly Felder xs t n Bli the ABI Comm’n to Study the Reform of Chapter 11, at 2–3 (Apr. 19, 2013) (“Post BAPCPA, DIP i Etlin: ASM Field Hearing Before cited agreements routinely require a full resolution to the case or rejection of any lease not consensually extended by the 210th day.  In the case of a retailer . . . [this] effectively shorten[s] the timeline to reorganize the company to generally only 120 days and sometimes as short as 90 days . . . .” and this generally means that the debtor’s management often has very little time to decide whether to pursue reorganization by obtaining consensual lease extensions or to begin a sale process.), available at Commission website, supra note 55; Oral Testimony of Richard Mikels: TMA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 40–42 (Nov. 3, 2012) (TMA Transcript) (arguing there should be a presumption against rollups, particularly where the company seeks to reorganize rather than sell), available at Commission website, supra note 55. See also Stephen J. Lubben, The Board’s Duty to Keep Its Options Open, 2015 Ill. L. Rev. __, at *4–5 (forthcoming 2015) (“But in many cases, the reality is that the debtor has no choice but to commence a sale process, because its DIP loan only provides funding for a relatively short period of time. Lenders are able to impose such terms on debtors because the lender has a virtual stranglehold on the debtor’s operations coming into bankruptcy by virtue of a lien on all of the debtor’s assets and possession of all the debtor’s cash.”), available at http:// papers.ssrn.com/sol3/papers.cfm?abstract_id=2434699. 302 See, e.g., Kenneth N. Klee & Richard Levin, Rethinking Chapter 11, 21 Norton J. Bankr. L. & Prac. 5 (2012) (discussing use of roll-ups and milestones in postpetition financing agreements); Supplemental Written Statement of Mark Shapiro: ABI Winter Leadership Conference Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 2–3 (Nov. 30, 2012) (reviewing various types of milestone, benchmark, roll-up, and other postpetition financing terms and their role in structuring and pricing the agreement; also addresses criticisms of such provisions), available at Commission website, supra note 55. 303 “When the debtor in possession’s prepetition lender is acting as the postpetition lender, the elimination of prepetition debt — termed a ‘roll–over’ — often attracts intense scrutiny from the court and the United States trustee. Roll-overs come in two basic forms. First, a gradual roll-over occurs when a prepetition lender agrees to advance postpetition funds with the agreement that proceeds of prepetition accounts receivables will be applied to reduce the prepetition loan. Alternatively, a postpetition lender can simply lend enough postpetition to pay off the prepetition loan, whether owing to the postpetition lender or a different lender, immediately converting all of the lender’s prepetition debt to postpetition debt. Postpetition lenders often prefer the latter alternative because they prefer to be the sole holder of a lien on the collateral pool.” 3 Collier on Bankruptcy ¶ 364.04[1] [e]. See also In re Capmark Fin. Grp. Inc., 438 B.R. 471, 511 (Bankr. D. Del. 2010) (explaining that a “roll-up” is “the payment of a pre-petition debt with the proceeds of a post-petition loan. Roll-ups most commonly arise where a pre-petition secured creditor is also providing a post-petition financing facility under section 364(c) or (d) of the Bankruptcy Code. The proceeds of the post-petition financing facility are used to pay off or replace the pre-petition debt, resulting in a post-petition debt equal to the pre-petition debt plus any new money being lent to the debtor. As a result, the entirety of the pre-petition and post-petition debt enjoys the post-petition protection of section 364(c) or (d) as well as the terms of the DIP order.”); Mark J. Roe & Frederick Tung, Breaking Bankruptcy Priority: How Rent-Seeking Upends The Creditors’ Bargain, 99 Va. L. Rev. 1235, 1238 (2013) (“[B]ank lenders have convinced judges to “roll up” their possibly unsecured pre-bankruptcy debts — debts that were quite likely not entitled to priority payment — into new, secured, and highly-prioritized loans to the debtor in bankruptcy.”). IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 84 of 402 Bankruptcy Institute facility and the true “new credit” extended by such facility may be nominal (or nominal in relation to the amount of prepetition debt rolled up into the postpetition facility).304 Although the Commission viewed a refinancing with a new lender differently, the Commission also noted the potential challenge in distinguishing among prepetition and postpetition lending groups. To assist in this task, the Commission methodically worked through the various scenarios in which one or more prepetition lenders may participate in a postpetition facility that provides new credit to the debtor in possession. The Commission crafted the related principles to allow roll-up provisions in those circumstances if certain conditions are met, but to disallow roll-up provisions that provide little or no value to the estate. With respect to cross-collateralization, the Commissioners discussed its uses and the split in the case law regarding the permissibility of cross-collateralization. The Commissioners articulated concerns similar to those expressed in the roll-up context. In fact, some of the Commissioners viewed crosscollateralization as subject to greater abuse because of the ability of prepetition lenders to improve their prepetition position through the use of cross-collateralization in postpetition facilities. As noted in the adequate protection principles above, the Commission ultimately supported the ability of a debtor in possession to use cross-collateralization, but only in the adequate protection context and only to the extent such cross-collateralization is used if there is actual diminution in the value of a secured creditor’s interest in the debtor’s property.305 6 The Commission considered whether a debtor in possession should be able1, 20grant postpetition to 1 ber 2 ve such actions to secure the lenders a lien in its chapter 5 avoidance actions or the proceedsoof m nN ed o postpetition facility. As discussed above in the adequate 3 archiv protection context, the Commission reviewed 3536 . 14the original policies underlying the trustee’soavoiding powers under chapter 5 of the Bankruptcy ,N own v. Brin such assets. The Commission determined that the debtor Code and the estate’s unique interests eth Blixs in possession shouldcnot ibe permitted to use chapter 5 avoidance actions or the proceeds of such ed n it actions (directly or indirectly through any superpriority claim) to secure postpetition financing under section 364 of the Bankruptcy Code. In the adequate protection context, section 507(b) of the Bankruptcy Code grants prepetition lenders a superpriority claim in situations when they have sought adequate protection, and adequate protection has failed. In contrast, a postpetition lender has other means to secure or protect its postpetition extension of credit to the debtor from the outset. The Commissioners also evaluated the impact of provisions in a prepetition intercreditor or subordination agreement that precludes a prepetition junior secured lender from offering postpetition financing to the debtor without the consent of the senior secured lender. This kind of waiver by a junior lender in the prepetition intercreditor agreement can have a significant negative impact on the debtor in possession, who is often not a party to the agreement. Among 304 The Commission considered the testimony of Mark Shapiro, who in part analyzed the LSTA data and concluded that only about 10 percent of the 167 observations (total sample) in the LSTA dataset involved a postpetition financing with roll-up provisions that resulted in the conversion of a case to chapter 7, approval of a section 363 sale of substantially all of its assets, or confirmation of a liquidating plan. Supplemental Written Statement of Mark Shapiro: ABI Winter Leadership Conference Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 7 (Nov. 30, 2012), available at Commission website, supra note 55. The Commissioners also observed in the LSTA dataset, however, a correlation between postpetition financing agreements with roll-up provisions and some type of milestone or benchmark requirement. Specifically, if the financing included a roll-up, it was more likely to also include milestones or benchmarks. These analyses were based on the data in Exhibit B to Mr. Shapiro’s supplemental testimony. Supplemental Written Statement of Mark Shapiro: ABI Winter Leadership Conference Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at Exhibit B (Nov. 30, 2012), available at Commission website, supra note 55. See generally supra note 66 and accompanying text (generally discussing limitations of chapter 11 empirical studies). 305 See Section IV.B.1, Adequate Protection.  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 85 of Chapter  other things, this waiver often removes an interested and viable source of financing from the debtor’s pool of potential postpetition lenders, which may affect both the availability and terms of any postpetition financing for the debtor in possession. The Commissioners recognized that this kind of waiver is increasingly common in intercreditor agreements, along with a variety of other provisions that affect bankruptcy rights, including rights of the debtor and potentially other nonparties to the intercreditor agreement. The Commissioners discussed the role and value of these provisions from the perspective of the prepetition senior secured lenders. The Commissioners debated different ways to provide the debtor with the ability to discuss postpetition financing with junior lenders subject to this kind of waiver while still respecting the interests of the prepetition senior secured lenders. The Commission reached a consensus that would allow a subordinated junior secured lender subject to this kind of waiver and prohibition to provide postpetition financing to the debtor on two conditions: (i) the proposed facility does not prime the liens of the prepetition senior secured lender, and (ii) if the court approves the postpetition facility offered by such junior lenders, the prepetition senior secured lender has the right to step in and provide postpetition financing (in lieu of the financing offered by the junior lender) to the debtor on the same terms and subject to the same conditions as the postpetition facility offered by the junior secured lender and approved by the court. In that event, the Commission supported an amendment to the Bankruptcy Code rendering unenforceable any contractual damages provisions that would otherwise allow senior secured creditors to recover damages for breach of contract against junior 16 306 secured creditors under nonbankruptcy law based on the provisionbof 21, 20 er postpetition financing. In em v addition, the Commission agreed that the senior secured lenders should be required to take such n No ed o chivin the interim financing order. action within a reasonable time as directed by 5363court the ar in cited -3 o. 14 n, N Brow th v. lixse B C. Breathing Spell for Debtor upon Filing 1. Timing of Approval of Certain Postpetition Financing Provisions Recommended Principles: A court should not approve any proposed postpetition financing under section 364 of the Bankruptcy Code that (i) is subject to milestones, benchmarks, or other provisions that require the trustee to perform certain tasks or satisfy certain conditions within 60 days after the petition date or date of the order for relief, 306 The Commission’s discussion of the use and approval of provisions in a postpetition facility that may impact the course of the chapter 11 case or implement waivers of, or otherwise affect, rights under the Bankruptcy Code is set forth in Section IV.C.1, Timing of Approval of Certain Postpetition Financing Provisions; Section VI.C.3, Section 506(c) and Charges Against Collateral; and Section VI.C.4, Section 552(b) and Equities of the Case. IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 86 of 402 Bankruptcy Institute whichever is later, or (ii) otherwise conflict with another section of the Bankruptcy Code. In this context, the phrase “milestones, benchmarks, or other provisions that require the trustee to perform certain tasks or satisfy certain conditions” refers to tasks or conditions that relate in a material or significant way to the debtor’s operations during the chapter 11 case or to the resolution of the case, including deadlines by which the debtor must conduct an auction, close a sale, or file a disclosure statement and a chapter 11 plan. It does not include payment of scheduled loan amounts, customary loan covenants, reporting requirements, ministerial tasks, or the debtor’s compliance with a budget, provided that the budget does not impose disguised milestones or benchmarks. A court should not approve permissible extraordinary financing provisions in connection with any proposed postpetition financing under section 364 in any interim order. In this context, “permissible extraordinary financing provisions” include: (i) milestones, benchmarks, or other provisions that require the trustee to perform certain tasks or satisfy certain conditions; (ii) representations regarding the validity 1 or extent of the creditor’s liens on the debtor’s property or property2of the 6 1, 20 estate; or ber m (iii) if some or all of the proposed postpetition lendersnholdeprepetition debt that Nov ed o that refinances prepetition would be affected by the postpetition facility, 3 provision a rchiv 6 a -353 debt with proceeds of the postpetition4facility that is otherwise permissible under .1 , No rown B the principles relating ttov.postpetition financing terms. See Section IV.B.2, Terms h xse n Bli i of PostpetitiondFinancing. cite For the recommended principles on section 506(c) and section 552(b), see Section VI.C.3, Section  506(c) and Charges Against Collateral; Section VI.C.4, Section 552(b) and Equities of the Case. Timing of Approval of Certain Postpetition Financing Provisions: Background Although an often necessary and critical source of postpetition liquidity, the postpetition facility negotiated between a debtor and its postpetition lenders may be subject to terms that could affect the chapter 11 case. For example, the terms of the proposed postpetition financing may require the debtor in possession307 to pursue a sale process under section 363 of the Bankruptcy Code on an expedited basis; may set certain deadlines for the debtor to file its disclosure statement and chapter 11 plan; may contain waivers of certain rights held by the debtor in possession under the Bankruptcy Code, such as the right to assert surcharges under section 506(c); or may exclude the application of certain other provisions of the Bankruptcy Code, such as the equities of the case exception under section 307 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model.  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 87 of Chapter  552(b). The facility may also be subject to provisions addressing the validity of any prepetition liens of the lenders, granting a lien in chapter 5 avoidance actions and any recoveries thereon, and default or termination provisions tied to a variety of developments in the particular chapter 11 case, such as motions for relief from the automatic stay or challenges to the liens held by postpetition lenders. Bankruptcy Rule 4001(c)(1)(B) requires the debtor in possession to provide a “concise statement” that “lists or summarizes . . . all material provisions of the proposed credit agreement and form of order, including interest rate, maturity, events of default, liens, borrowing limits, and borrowing conditions.” In addition, many jurisdictions supplement this requirement in their local rules with, among other things, provisions that require additional disclosures and limit the effect and extent of interim orders.308 Bankruptcy Rule 4001(c)(2) requires the debtor in possession to provide at least 14 days’ notice of the court’s final hearing on a motion to obtain postpetition financing; however, many cases involve an interim hearing and the entry of an interim order shortly after the petition date and then a final hearing and the entry of a final order only after the statutory committee of unsecured creditors has been appointed and has had an opportunity to review and respond to the debtor’s motion for the requested relief. Timing of Approval of Certain Postpetition Financing Provisions: Recommendations and Findings 6 1 1, 20 ber 2 in a postpetition credit em The Commissioners discussed at length the potential impact vof terms n No ed o the chapter 11 case, or that implement agreement that dictate or attempt to influence the course of rchiv 63 a -353 waivers of, or otherwise affect, rights under4the Bankruptcy Code.309 The Commissioners identified .1 , No rowninto this category, including (i)  milestones and benchmarks a variety of provisions that th v. B fall may se that require the debtorBlix take certain actions or satisfy certain conditions by deadlines set forth in n to i cited the postpetition financing documents; (ii) concessions regarding the validity or enforceability of prepetition liens; (iii) deadlines by which the debtor must conduct an auction, close a sale, or file a disclosure statement and chapter 11 plan; and (iv) waivers of, or stipulations concerning, the section 506(c) surcharge and the section 552(b) equities of the case exception.310 Although Bankruptcy Rule 4001(c) requires the debtor to summarize these kinds of provisions, parties in interest may not have sufficient time or information to accurately assess the import of such provisions and the impact they may have on the case. Notably, the data compiled by the LSTA included information concerning postpetition financing with the following kinds of milestones or benchmarks: “Milestone re Bidding Procedures Orders,” “Milestone re Sale Orders,” “Milestone re Closing a Sale,” and “Conditions for 308 See, e.g., Southern District of New York Bankruptcy Court Local Rule 4001-2. 309 See Written Statement of Kathryn Coleman, Attorney at Hughes Hubbard & Reed, LLP: TMA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 6–7 (Nov. 3, 2012), (describing how onerous the conditions of postpetition financing can be, including use of provisions that require a section 363 sale within 60 days of the lending date), available at Commission website, supra note 55; Written Statement of Lawrence Gottlieb, Partner, Cooley LLP: NYIC Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 5 (June 4, 2013) (discussing how prepetition secured lenders of retail debtors demand postpetition financing provisions that result in quick liquidation sales), available at Commission website, supra note 55; Written Statement of Elizabeth Holland on behalf of the International Council of Shopping Centers: NYIC Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 5 (June 4, 2013) (describing how restrictive DIP lending conditions prevent retail debtors from reorganizing), available at Commission website, supra note 55; Written Statement of David L. Pollack, Partner, Ballard Spahr LLP: NYIC Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 2–3 (June 4, 2013) (describing how postpetition financing terms have prevented retail reorganizations), available at Commission website, supra note 55. 310 The Commission addressed this latter category in Section VI.C.3, Section 506(c) and Charges Against Collateral and in Section VI.C.4, Section 552(b) and Equities of the Case. IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 88 of 402 Bankruptcy Institute the Bidding Process for a 363 Sale.”311 A review of the 112 observations in the LSTA dataset with postpetition financing agreements (112 of 167 total sample) revealed that a postpetition facility subject to certain milestones or benchmarks in the chapter 11 case actually produced the required result — i.e., postpetition credit agreements that required a section 363 sale resulted in a section 363 sale, and postpetition credit agreements that required the filing of a plan resulted in a confirmed plan.312 Moreover, postpetition financing facilities with sale-oriented milestones were significantly less likely to result in a reorganization, as shown in the table below.313 Proportion of Debtors (%) Whether Postpetition Facility Had Sale Milestones 16 1, 20 ber 2 vem n No ed o rchiv 63 a -353 . 14 , No rown B h v. xset n Bli BETWEEN CHAPTER 11 REORGANIZATION AND i RELATIONSHIP cited SALE MILESTONES IN POSTPETITION FACILITY 311 These milestones are defined as follows: Milestone re Bidding Procedures Orders: If there was DIP Financing, was it an event of default not to have an order approving the bidding procedures for a sale of substantially all of the debtor’s assets entered by a certain date? Yes/No. Milestone re Sale Orders: If there was DIP Financing, was it an event of default not to have an order approving a sale of substantially all of the debtor’s assets entered by a certain date? Yes/No. Milestone re Closing a Sale: If there was DIP Financing, was it an event of default not to [close a sale] by a certain date? Yes/No. Conditions for the Bidding Process for a 363 Sale: If there as a DIP Financing, did it the process under which any auction of the debtor’s assets had to occur? Yes/No. Supplemental Written Statement of Mark Shapiro: ABI Winter Leadership Conference Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at Exhibit A p.4 (Nov. 30, 2012), available at Commission website, supra note 55. 312 Based on the LSTA dataset, if the postpetition financing agreement contained a sale-related milestone or benchmark, the case was more likely to result in a sale or liquidation. This relationship was statistically significant at the 1.0 percent level. These analyses were performed using logistic regression, confirmed by the Chi Squared test, the Chi Squared Test with Yates Correction test, and the Likelihood Ratio test. These analyses were based on the data in Exhibit B to Mr. Shapiro’s supplemental testimony. Supplemental Written Statement of Mark Shapiro: ABI Winter Leadership Conference Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at Exhibit B (Nov. 30, 2012), available at Commission website, supra note 55. See also Written Statement of Kathryn Coleman, Attorney at Hughes Hubbard & Reed, LLP: TMA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 22 (Nov. 3, 2012) (stating that DIP lenders often require debtors to obtain the lenders’ consent for any action outside the ordinary course of business, including filing a plan, and require the sale of the debtors’ assets in a very short period of time, such as 60 days), available at Commission website, supra note 55. See generally supra note 66 and accompanying text (generally discussing limitations of chapter 11 empirical studies). 313 Mr. Roberts prepared this chart for the Commission based on data from the LSTA dataset.  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 89 of Chapter  The Commissioners discussed ways to provide more effective notice of these kinds of provisions to the unsecured creditors’ committee and other parties in interest in the debtor’s chapter 11 case, and highlighted the need to provide these parties with sufficient time to review and vet such provisions. In light of the potentially significant impact of these provisions on chapter 11 outcomes, the Commission determined that such extraordinary provisions in postpetition facilities should be highlighted and clearly explained in the motion seeking approval of the postpetition financing. In addition, the Commission agreed that (i) such extraordinary provisions should not be subject to approval in an interim order, and (ii) milestones, benchmarks, or similar provisions should not be permitted to take effect until at least 60 days after the petition date. 2. Timing of Section 363x Sales Recommended Principles: The trustee should not be permitted to conduct an auction of, or to receive final approval of a sale transaction involving, all or substantially all of the debtor’s assets within 60 days after the petition date or date of the order for relief, whichever is later. The court should not shorten this 60-day moratorium unless (i) the trustee or a party in interest demonstrates by clear and convincing evidence that there is a high likelihood that the value of the debtor’s assets will decrease significantly 2016 r 21, beproposed sale satisfies during such 60-day period, and (ii) the court finds thatethe v m n No ed o 363x sales. See Section VI.B, the standards set forth in the principles archsection for iv 63 -353 the purposes of this rule, the court may Approval of Section 363x Sales.14 o. For n, N rowor not the secured creditor has requested or received B authorize a sale whether h v. xset n Bli i adequatedprotection of its interests under section 361 of the Bankruptcy Code if cite the risk of decrease in the value of the debtor’s assets is sufficient to warrant a sale before the expiration of the 60-day moratorium. Timing of Section 363x Sales: Background Section 363 of the Bankruptcy Code currently allows the trustee314 to sell assets in the ordinary course of business as well as outside the ordinary course of business during the chapter 11 case.315 A sale outside the ordinary course of business requires, among other things, notice and a hearing. It also typically requires an auction and public sale process.316 Although courts frequently use the 314 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. 315 11 U.S.C. § 363(b), (c). 316 See Rachael M. Jackson, Survey: Responding to Threats of Bankruptcy Abuse in a Post-Enron World: Trusting the Bankruptcy Judge as the Guardian of Debtor Estates, 2005 Colum. Bus. L. Rev. 451, 469–70 (2005) (“The process of conducting an auction generally establishes that a successful bidder has paid the fair market value for the asset. Therefore, considering the tremendous emphasis that bankruptcy courts place on maximizing the value of the estate, auction sales are advisable because judges do not tend to scrutinize closely such transactions before approving the final sale. In addition, the security of an auction sale is enhanced because appellate courts review bankruptcy court confirmations with considerable deference and, therefore, disgruntled bidders are rarely successful in challenging a court-approved sale.”); Brett Rappaport & Joni Green, Calvinball Cannot Be Played on This Court: The Sanctity of Auction Procedures in Bankruptcy, 11 Norton J. Bankr. L. & Prac. 189, 193 (2002) (“Public auctions are preferred over private auctions to ensure a market price, so that optimal return can be realized for creditors.”); Philip A. Schovanec, Bankruptcy: The Sale of Property Under Section 363: The Validity of Sales Conducted Without Proper Notice, 46 Okla. L. Rev. 489, 498 n. 63 (1993) (“While bankruptcy sales may be conducted privately, a public auction is usually held because IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 90 of 402 Bankruptcy Institute auction process as a means to ensure that the assets are sold for the best and highest price, the plain language of section 363 and of the Bankruptcy Rules do not expressly require an auction and public sale process, and courts will, in certain instances, approve private sale transactions. Courts also have long debated whether section 363 permits the sale of all or substantially all of a debtor’s assets prior to the filing and confirmation of a chapter 11 plan.317 The primary concerns of courts and commentators with this practice are premised on the absence of stakeholder protections that are otherwise incorporated into the section 1129 plan process: section 1125 requires meaningful disclosures; section 1126 requires a vote by holders of impaired claims and interests; section 1129 requires, among other things, that the plan (i) satisfy administrative and certain other claims against the estate; (ii) be in the best interests of creditors; and (iii) be accepted by all impaired classes of creditors, or have the support of at least one class of impaired creditors and be fair and equitable.318 In addition, sales of all or substantially all of a debtor’s assets on an expedited basis, particularly early in the chapter 11 case, can raise concerns about (a) the proper valuation and marketing of assets, (b) whether other restructuring alternatives were fully explored, and (c) whether the court, the U.S. Trustee, and stakeholders have sufficient information and time to review and comment on the proposed transaction.319 Courts have been increasingly willing to approve expedited sales of all or substantially all of a debtor’s assets, provided that a debtor can demonstrate exigency and certain other showings. This section 16 1, 20 addresses the timing of such sales; the requirements for the approvalmbesuch sales are discussed of r 2 ve n No below.320 ed o rchiv 3a 3536 . 14, No Prior to the early 2000s, a traditional chapter 11 sale process under section 363 could take at least own v. Br et three months, if not more.321 liThishcourse typically involved a thorough postpetition marketing and B xs ed in cit 317 318 319 320 321  competitive bidding ensures that fair and valuable consideration is received, thus helping to avoid any suspicion of collusion or impropriety.”). The Second Circuit in Lionel examined this debate, as well as whether a sale of all or substantially all of a debtor’s assets should be permitted absent an emergency situation. In re Lionel Corp.,722 F.2d 1063, 1066 (2d Cir. 1983) (explaining, among other things, the history of section 363 sales, which the court traced to the Bankruptcy Act of 1867, and noting that under the 1867 Bankruptcy Act, “when it appears . . . that the estate of the debtor, or any part thereof, is of a perishable nature or liable to deteriorate in value, the court may order the same to be sold, in such manner as may be most expedient”) (internal quotation marks omitted). The Second Circuit determined that such sales should be permitted but not without standards: Just as we reject the requirement that only an emergency permits the use of § 363(b), we also reject the view that § 363(b) grants the bankruptcy judge carte blanche . . . such construction of §  363(b) swallows up Chapter 11’s safeguards. . . . [T]here must be some articulated business justification, other than appeasement of major creditors for using, selling or leasing property out of the ordinary course of business before the bankruptcy judge may order such disposition under 363(b). Id. at 1069–70. 11 U.S.C. § 1129(a), (b). See, e.g., In re Fisker Auto. Holdings, Inc., 510 B.R. 55, 60–61 (Bankr. D. Del. 2014) (“It is the Court’s view that Hybrid’s rush to purchase and to persist in such effort is inconsistent with the notions of fairness in the bankruptcy process. The Fisker failure has damaged too many people, companies and taxpayers to permit Hybrid to short-circuit the bankruptcy process.”); In re On-Site Sourcing, Inc., 412 B.R. 817, 824 (Bankr. E.D. Va. 2009) (listing the following nine areas of concern when analyzing a section 363 motion seeking expedited relief: (1) Is there evidence of a need for speed? (2) What is the business justification? (3) Is the case sufficiently mature to assure due process? (4) Is the proposed APA sufficiently straightforward to facilitate competitive bids or is the purchaser the only potential interested party? (5) Have the assets been aggressively marketed in an active market? (6) Are the fiduciaries that control the debtor truly disinterested? (7) Does the proposed sale include all of a debtor’s assets and does it include the ‘crown jewel’? (8) What extraordinary protections does the purchaser want? (9) How burdensome would it be to propose the sale as part of confirmation of a chapter 11 plan?) (citation omitted). See Section VI.B, Approval of Section 363x Sales. Cases typically provided set deadlines for a meaningful auction process and then sufficient time for objections to, and a hearing on, the sale transaction itself. In addition, Bankruptcy Rule 2002(a)(2) requires 21 days’ notice by mail of “a proposed use, sale or lease of property of the estate other than in the ordinary course of business, unless the court for cause shown shortens the time or directs another method of giving notice.” Fed. R. Bankr. P. 2002(a)(2). IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 91 of Chapter  auction process; sufficient opportunity for notice, objections, and hearings on both the auction process and sale transaction; and the closing of the sale.322 This practice allowed the court, the debtor in possession, the U.S. Trustee, and parties in interest a full opportunity to consider the value of the assets and alternatives to a sale, instilled a certain level of confidence in the bankruptcy sale process, and resulted in the conclusion that the approved sale was in the best interests of the estate. In recent years, the sale process has become much more abbreviated. Although the General Motors and Chrysler323 chapter 11 cases — in each case a section 363 sale was completed in approximately 41 days — were more fast-paced than many cases, the average time between the petition date and the sale date has steadily decreased, as illustrated by the following chart.324 in cited 16 1, 20 ber 2 vem n No ed o rchiv 63 a -353 . 14 , No rown .B eth v Blixs Note: In this bar chart above, the y-axis shows the number of days between the petition date and the date of the sale order for a sale of all or substantially all of the debtor’s assets. The median number of days between the petition date and the sale order approving a section 363 sale has declined from a high of 1982 days in 1992 to 51 days in 2012. Notably, in some years, the data only show one (e.g., 1992) or just a few orders approving section 363 sales for substantially all of the debtor’s assets. (These data may not have captured sales, for example, consummated through a plan of reorganization, which was coded separately in the dataset.) The table below identi es the number of section 363 sale orders per year, as well as the mean and median duration between the petition date and the sale order. 322 For a general description of the steps required in a typical sale and auction process under section 363(b), see, e.g., In re Adoption of Amended Guidelines for the Conduct of Asset Sales, General Order Amending M-331, M-383 (Bankr. S.D.N.Y. Nov. 18, 2009), available at http://www.nysb.uscourts.gov/sites/default/files/m383.pdf. 323 See, e.g., In re Gen. Motors Corp., 407 B.R. 463, 491–92 (Bankr. S.D.N.Y. 2009), aff ’d sub nom. In re Motors Liquidation Co., 430 B.R. 65 (S.D.N.Y. 2010); In re Chrysler LLC, 405 B.R. 84, 96 (Bankr. S.D.N.Y. 2009), appeal dismissed, 592 F.3d 370 (2d Cir. 2010). See also In re Lehman Bros. Holdings Inc., Case No. 08-13555 (Bankr. S.D.N.Y 2008) (sale approved within seven days of petition date). 324 Mr. Shrestha prepared this chart and table for the Commission based on data from the UCLA-LoPucki Bankruptcy Research Database. Accordingly, it was limited to large public companies. The duration above is the time between the petition date and the date of the sale order. IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 92 of 402 Bankruptcy Institute DURATION BETWEEN BANKRUPTCY FILING AND SECTION 363 SALE ORDER Year Mean No. of Days Median No. of Days 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 156 97 1,982 868 127 203 114 470 137 275 156 97 1,982 868 80 203 114 249 109 219 No. of 363 Sales 2 2 1 2 3 2 2 7 14 22 Year Mean No. of Days Median No. of Days No. of 363 Sales 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 287 227 72 63 205 34 187 81 134 116 63 82 102 140 68 63 205 34 110 77 95 141 51 74 15 15 3 2 2 2 12 17 5 3 4 3 The speed with which section 363 sales are now approved and consummated causes some courts, stakeholders, and commentators to question whether value is being removed from the estate by permitting a value realization event such as a sale too early and too quickly in a chapter 11 case.325 016 Many commentators recognize that there could be exceptions — true “melting1, 2 cubes” that require ber 2 ice vem n No immediate resolution to preserve any value for the estate — but those exceptions, they argue, should ed o rchiv 63 a not define the rules.326 -353 . 14 , No rown .B eth v Blixs Timing of Sectionted in Sales: Recommendations and Findings 363x ci The Commissioners examined the process relating to a sale of all or substantially all of a debtor’s assets (referred to as a “section 363x sale” in these principles) at great length. In addition to reconsidering 325 See, e.g., Jessica Uziel, Section 363(b) Restructuring Meets the Sound Business Purpose Test with Bite: An Opportunity to Rebalance the Competing Interests of Bankruptcy Law, 159 U. Pa. L. Rev. 1189, 1214 (2011) (“Section 363 sales’ expedited process and lesser disclosure requirements make investigation of the purchaser’s behavior vital in order to protect creditors, equity security holders, and debtors from exploitation. Increased potential for abuse threatens creditors’ interests as well as the debtor’s ability to maximize the value of the estate.”); Elizabeth B. Rose, Chocolate, Flowers, and § 363(b): The Opportunity for Sweetheart Deals Without Chapter 11 Protections, 23 Emory Bankr. Dev. J. 249, 272 (2006) (“Without comprehensive information available to the court and the committee the sale is vulnerable to sweetheart deals or unfair dealing.”). See generally Lynn M. LoPucki & Joseph W. Doherty, Bankruptcy Fire Sales, 106 Mich. L. Rev. 1 (2007) (comparing recoveries from bankruptcy sales of large corporations to those of bankruptcy reorganizations from 2000 to 2004). But see Written Statement of Honorable Melanie Cyganowski (Ret.), former U.S. Chief Bankruptcy Judge, E.D.N.Y.: CFA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 4 (Nov. 15, 2012) (asking the Commission not to impose a delayed time frame for section 363 sales), available at Commission website, supra note 55. “In the SMEs and middle-market cases, the Chapter 11 debtors have, in many instances, little flexibility, little bargaining power and even more minimal lines of credit. The Court needs in many instances to force a sale on very short notice . . . to maximize value for the estate.” Id. But see Written Statement of Robert D. Katz, Managing Director of Executive Sounding Board Associates Inc.: CFA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 2–4 (Nov. 15, 2012) (asking the Commission not to impose a delayed time frame for section 363 sales), available at Commission website, supra note 55. 326 A “melting ice cube” case refers to a case involving assets subject to rapid decline because of the nature of such assets (often referred to as “perishable” assets) or unique, exigent circumstances that cannot otherwise be avoided. For a general discussion of these cases and some of the challenges they pose, see Jacoby & Janger, Ice Cube Bonds, supra note 283. The challenge for most courts is that bankruptcy by its nature often is an emergency procedure, so articulating a need to sell today as opposed to tomorrow is easy; assessing the validity of that assertion is not. See, e.g., In re Humboldt Creamery, LLC, 2009 WL 2820610, at *2 (Bankr. N.D. Cal. Aug. 14, 2009) (“[T]he problem with the ‘melting ice cube’ argument is that it is easy enough for the debtor to unplug the freezer prior to bankruptcy.”); In re Gulf Coast Oil Corp., 404 B.R. 407, 423 (Bankr. S.D. Tex. 2009) (“The Court must be concerned about a slippery slope. Not every sale is an emergency, and, as discussed more fully below, the reliability of uncontested evidence (and particularly the reliability of testimony that is not adequately cross-examined) is suspect.”).  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 93 of Chapter  the standard of review and substantive requirements for section 363x sales, the Commission also scrutinized the timing issues surrounding these sales. The Commissioners discussed the potential benefits to a quick sale — e.g., potentially less time in chapter 11; potentially less expensive reorganization strategy; typically preferred by postpetition lenders and prepetition secured creditors because of faster payoff; and typically preferred by stalkinghorse bidders because a quick sale disfavors outside bidders.327 The Commission also recognized that if a debtor’s business assets are of a perishable nature or otherwise subject to a rapid decline in value, then a quick sale may be the best and perhaps only option for maximizing value for the estate and its stakeholders. The Commission generally agreed, however, that section 363x sales are proceeding more quickly than is necessary in many chapter 11 cases. The Commissioners noted that quicker than necessary sales can potentially reduce the value available for stakeholders in the chapter 11 case. Such a sale may (i) not facilitate a robust auction, (ii) not allow the debtor sufficient time to explore a standalone reorganization or other restructuring alternatives, and (iii) take advantage of a decline in the applicable markets without giving parties in interest a reasonable time to assess the likelihood that such markets will rebound during the pendency of the debtor’s chapter 11 case. The Commissioners also acknowledged the problems with insufficient notice and opportunity for parties in interest to assert meaningful objections or perform reliable asset valuations within the abbreviated time frames 6 , 201 of a quick sale. er 21 b ovem on N ved After extensive deliberation, the Commission found thatiin many cases, the potential harm to the estate arch 363 - 5 from a sale that is pushed through the ,process3more quickly than necessary under the circumstances o. 14 n N Brow significantly outweighs any tpotential benefits of such a sale. Accordingly, the Commission agreed h v. lixse that the Bankruptcy in B should include a 60-day moratorium on section 363x sales, absent the cited Code most extraordinary of circumstances, which must be established by clear and convincing evidence at the hearing on the motion requesting an expedited sale process. D. Payment of Certain Claims upon Filing When a debtor files a chapter 11 case, the automatic stay of section 362 of the Bankruptcy Code prohibits the debtor in possession from paying any prepetition claims outside the chapter 11 plan or without prior approval of the court. A key factor underlying this prohibition is that sections 507 and 1129 of the Bankruptcy Code incorporate a fairly stringent priority scheme for the payment of prepetition claims. Payments outside the chapter 11 plan may result in an unfair allocation of value among stakeholders in the chapter 11 case. 327 First Report of the Commercial Fin. Ass’n to the ABI Comm’n to Study the Reform of Chapter 11: Field Hearing at Commercial Fin. Ass’n Annual Meeting, at 5 (Nov. 15, 2012) (“CFA submits that promoting an efficient sale of collateral to a purchaser who is able to continue to use those assets in a productive form is good for the economy in general and for the selling debtor’s stakeholders in particular.”), available at Commission website, supra note 55. IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 94 of 402 Bankruptcy Institute Nevertheless, a debtor in possession strives to achieve a soft landing in chapter 11, which requires the continuation of “business as usual” to the greatest extent possible. A debtor in possession thus frequently requests court authorization to pay certain prepetition claims that are asserted to be either necessary to the ongoing operations of the business or are consistent with the priority rules set forth in section 507. 1. Prepetition Claims and the Doctrine of Necessity Recommended Principles: The court should have the authority to enter an order permitting the payment of certain prepetition claims when such remedy is directed toward: (i) employee wages or other compensation; or (ii) claims for vendor goods or services for which the trustee establishes an evidentiary record supporting such extraordinary relief, provided that any such relief should not include claims for the kinds of goods covered by section 503(b)(9) of the Bankruptcy Code unless the court finds some relief is compelled for a particular kind of good by applicable nonbankruptcy law that is not otherwise preempted by the Bankruptcy Code and is not deemed a disguised priority. 16 1, 20 ber 2 503(b)(9) For a discussion of section 503(b)(9), see Section V.E.1, vSection em n No ed o Reclamation. rchiv 63 a -353 . 14 , No rown v. B seth n Bli Prepetition Claimsdandxthe Doctrine of Necessity: Background i cite and The doctrine of necessity originates from the early railroad equity receivership cases.328 In those cases, courts generally granted priority status to the railroad’s current operating expenses that were incurred within six months of the filing and were deemed necessary to keep the railways and interstate commerce moving.329 Although not expressly authorized by the Bankruptcy Code, courts have continued to invoke the doctrine of necessity330 in certain circumstances under the court’s general equitable powers set forth in section 105(a) of the Bankruptcy Code.331 328 See, e.g., Miltenberger v. Logansport, 106 U.S. 286 (1882), superseded by statute, Bankruptcy Act of 1898, as recognized in In re Kmart Corp., 359 F.3d 866, 871 (7th Cir. 2004), cert. denied, 543 U.S. 986 (2004) (payment of pre-receivership claims to prevent interruption in business). 329 Id. 330 See, e.g., In re Just For Feet, Inc., 242 B.R. 821, 826 (D. Del. 1999); In re NVR L.P., 147 B.R. 126, 128 (Bankr. E.D. Va. 1992); In re Eagle-Picher Indus., Inc., 124 B.R. 1021, 1023 (Bankr. S.D. Ohio 1991); In re Ionosphere Clubs, Inc., 98 B.R. 174 (Bankr. S.D.N.Y. 1989). 331 Section 105(a) provides: The court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title. No provision of this title providing for the raising of an issue by a party in interest shall be construed to preclude the court from . . . taking any action or making any determination necessary or appropriate to enforce or implement court orders or rules, or to prevent an abuse of process. 11 U.S.C. § 105(a). Notably, some courts have found or suggested authority to authorize the payment of critical vendor claims under section 363(b) of the Bankruptcy Code. See, e.g., In re Kmart Corp., 359 F.3d 866 (7th Cir. 2004), cert. denied, 543 U.S. 986 (2004); In re Ionosphere Clubs, Inc., 98 B.R. 174 (Bankr. S.D.N.Y. 1989).  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 95 of Chapter  Debtors in possession332 commonly rely on the doctrine of necessity and the court’s equitable powers when requesting authority to pay prepetition claims outside the chapter 11 plan. One type of claim that a debtor in possession seeks to pay is the so-called “critical vendor” claim. “Critical vendors” are commonly defined as essential vendors or suppliers who are indispensable to the debtor’s business — either because of the types of goods or services they supply, their knowledge of the debtor’s business, or some other unique aspect to the business relationship — and without whom the debtor likely cannot achieve a successful reorganization.333 A debtor’s request typically will propose conditions for the payment of these claims, such as percentage payments and an agreement that the vendor or supplier will continue with the debtor on the same terms as their prepetition agreement. Courts authorizing the payment of critical vendor claims generally rely on the doctrine of necessity and section 105(a).334 Notably, not all courts agree that the doctrine of necessity and section 105(a) can be used for these purposes.335 Prepetition Claims and the Doctrine of Necessity: Recommendations and Findings Whether the Bankruptcy Code should condone the early or priority payment of the prepetition claims of certain “critical vendors” may be influenced by the Bankruptcy Code’s treatment of certain vendor claims as “administrative claims” under section 503(b)(9). The Commission separately analyzed 16 the treatment of vendor claims under section 503(b)(9).336 As discussed 2below, the Commission 1, 0 ber 2 em recommended the continued application of section 503(b)(9). vIn making this recommendation, n No ed o rchiv however, the Commission also determined that section 503(b)(9) should be the sole remedy available 63 a -353 to creditors who are deemed eligible toNo. 14 early or priority payment on their prepetition claims , receive own v. Br against the debtor. seth ix in Bl cited The Commission reviewed justifications most commonly articulated to support critical vendor payments. These include a debtor’s need to: (i) continue to receive a steady supply of goods and services required for the operation of the debtor’s business; (ii) appease creditors who threaten to discontinue supply or services without payment; (iii) obtain products from a single-source supplier; (iv) comply with applicable state or other nonbankruptcy law that requires performance on a contract and is not otherwise preempted by the Bankruptcy Code; and (v) make payments that may be necessary for the survival of a key vendor.337 The Commissioners noted the danger of viewing 332 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. 333 See, e.g., In re Just For Feet, Inc., 242 B.R. 821 (D. Del. 1999). 334 Courts continued to use the doctrine in connection with their authority under section 105 to authorize, among other things, payments deemed necessary to the debtor’s reorganization efforts. See, e.g., In re Just For Feet, Inc., 242 B.R. 821, 826 (D. Del. 1999); In re NVR L.P., 147 B.R. 126, 128 (Bankr. E.D. Va. 1992); In re Eagle-Picher Indus., Inc., 124 B.R. 1021, 1023 (Bankr. S.D. Ohio 1991); In re Ionosphere Clubs, Inc., 98 B.R. 174 (Bankr. S.D.N.Y. 1989). 335 For courts rejecting the use of section 105 and the doctrine of necessity to authorize the payment of prepetition claims, see, e.g., In re Kmart Corp., 359 F.3d 866 (7th Cir. 2004), cert. denied, 543 U.S. 986 (2004); Chiasson v. J. Louis Matherne & Assocs. (In re Oxford Mgmt., Inc.), 4 F.3d 1329 (5th Cir. 1993); Official Comm. of Equity Sec. Holders v. Mabey, 832 F.2d 299 (4th Cir. 1987), cert. denied, 485 U.S. 962 (1988); B&W Enters., Inc. v. Goodman Oil Co. (In re B&W Enters., Inc.), 713 F.2d 534 (9th Cir. 1983). 336 See Section V.E.1, Section 503(b)(9) and Reclamation. 337 See, e.g., J.M. Blanco, Inc. v. PMC Mktg. Corp., 2009 WL 5184458, at *2 (D.P.R. Dec. 22, 2009) (debtor offered evidence to support that critical vendor supplied “merchandise [that] was critical and that no other vendor was available to offer the same inventory under equal terms and conditions”); In re Tropical Sportswear Int’l Corp., 320 B.R. 15, 20 (Bankr. M.D. Fla. 2005) (“This Court finds that the Debtors’ situation with its Critical Vendors is precisely the situation where critical vendor status is warranted. Each of the four Critical Vendors is a major supplier of specialty goods or services to the Debtors, and any interruption in the flow of their products to the Debtors would substantially jeopardize the Debtors’ ability to conduct business. As such, the Critical IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 96 of 402 Bankruptcy Institute these needs in isolation without considering the rights of other stakeholders and commonly applied protections of the Bankruptcy Code, such as the automatic stay in section 362. Although the Commissioners generally understood the potential hardship imposed on certain vendors by the automatic stay and the nonpayment of prepetition claims, some of the Commissioners observed that critical vendors are not substantively distinguishable from other prepetition creditors and should therefore be similarly situated. These Commissioners warned against the dangers of diluting various protections provided by the Bankruptcy Code that were originally intended to allow a debtor to catch its financial breath, assess its financial and operational condition under the protection of the automatic stay, and develop a plan that would treat all similarly situated creditors alike.338 The increasing categories of priority claims have reduced the debtor’s discretionary cash resources and made priority payments the rule rather than the limited exception they were intended to be. The Commission decided to recommend that the Bankruptcy Code specifically authorize the payment of prepetition claims to vendors for goods and services in certain instances, provided that such vendors are not eligible for administrative priority under section 503(b)(9). (As discussed in the context of section 503(b)(9), the Commissioners found that the priority afforded to vendor claims under section 503(b)(9) should provide sufficient protection and incentive for vendors to continue doing business with the debtor in possession.) In reaching its conclusion, the Commission 6 recognized that certain vendors may in fact be indispensable to the debtor’s201 1, reorganization but ber 2 ve without some compromise not be eligible for section 503(b)(9) treatment and unable to performm n No ed o rc iv and payment of their prepetition claims. The Commissionhdetermined, however, that the standard 63 a -353 should be stringent and require evidence to No. 14 why, for example, the debtor cannot obtain the , establish own v. Br the state law obligation is not preempted by the Bankruptcy particular services from another source, eth Blixs Code, or the state lawitobligation is not otherwise deemed an impermissible disguised priority. The ed in c Commission agreed that clarifying the court’s ability to authorize the payment of prepetition vendor claims under the Bankruptcy Code would reduce uncertainty and litigation, as well as the related costs, for the estate and creditors. In the context of prepetition vendor claims for goods, the Commission considered instances in which state law might prohibit a nondebtor party from providing goods to a debtor that has not paid a vendor’s invoices. The Commissioners analyzed whether the Bankruptcy Code needed to provide the court and the debtor in possession some flexibility in this context to preserve the business. In so doing, the Commissioners discussed the federal preemption doctrine, which is rooted in the Vendors are absolutely critical to the maintenance of the Debtors’ estates.”). See also Joseph Gilday, “Critical” Error: Why Essential Vendor Payments Violate the Bankruptcy Code, 11 Am. Bankr. Inst. L. Rev. 411, 416 (2003) (“Debtor’s counsel usually claims that losing such services or products would have, in the words of one, a ‘severely pernicious effect on [its] efforts to rehabilitate and reorganize.’ The inability to operate its business as it normally does would decrease the debtor’s cash flow and cripple its operations before it had a chance to propose a reorganization plan, according to its counsel.”) (citations omitted). 338 See Mason v. Official Comm. of Unsecured Creditors (In re FBI Distrib. Corp.), 330 F.3d 36, 41–42 (1st Cir. 2003) (“[T]he fundamental principle of bankruptcy law [is] that the debtor’s limited resources are to be distributed equally among similarly situated creditors [so] . . . statutory priorities are narrowly construed. . . .”); In re Mirant Corp., 296 B.R. 427, 429 (Bankr. N.D. Tex. 2003) (“[T]his court has reservations about granting such relief [to critical vendors] when to do so could result in certain favored unsecured creditors receiving treatment preferential to that received by other unsecured creditors under a plan.”); In re Structurlite Plastics Corp., 86 B.R. 922, 932 (Bankr. S.D. Ohio 1988) (“[R]e-payment of pre-petition debt should not be authorized as a result of threats or coercion by disgruntled creditors. Such activity violates the automatic stay imposed by 11 U.S.C. § 362(a) and, if tolerated, would negate the fundamental principle of equality of treatment among similarly situated creditors.”).  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 97 of Chapter  Supremacy Clause of the U.S. Constitution,339 and its well-established application to override state bankruptcy laws that interfere with federal bankruptcy law.340 The distributional requirements and priority rules under Bankruptcy Code section 507 therefore preempt any contrary state laws that seek to grant priority to certain claims.341 For example, Bankruptcy Code section 545 was enacted specifically to preempt statutory liens that are not good against a bona fide purchaser under state law.342 The Commissioners analyzed these concepts in trying to balance a debtor in possession’s need to satisfy a nonbankruptcy law requirement that was not a disguised priority in order to continue its business operations and the general restraints of the doctrine of necessity and federal bankruptcy priorities. In striking this balance with respect to state laws applicable to vendor goods, the Commission articulated a standard similar to that imposed by courts under section 545: courts should not authorize payment of prepetition claims that become due upon the debtor’s insolvent financial condition or the commencement of the debtor’s bankruptcy case, or have no legitimate purpose outside the bankruptcy context.343 The Commission did not address or recommend codification of standards to allow the payment of other prepetition claims that may be permissible under current bankruptcy law and the doctrine of necessity. Rather, other than the two categories of claims specifically addressed in the recommended principles, the Commission determined that such claims should continue to be governed by current law. 16 1, 20 ber 2 ovem n which shall 339 U.S. Const. art. VI, ¶ 2 (“This Constitution, and the laws of the United States N and all ed oStates, shall be be made in pursuance thereof;and the treaties made, or which shall be made, under the authority of the hiv the supreme law of the land; arc United judges in every state shall be bound thereby, anything4-3the 63 in 53 Constitution or laws of any State to the contrary notwithstanding.”). 1 340 Stellwagen v. Clum, 245 U.S. 605, 613 (1918) ,(“In .view of this grant of authority [over bankruptcy] to the Congress it has been No n settled from an early date that state laws row extent that they conflict with the laws of Congress, enacted under its constitutional . Bto the eth v authority, on the subject of lbankruptcies are suspended.”). ixs i B 341 “Under the SupremacynClause, U.S. Const. Art. VI, contrary provisions of state law must give way before the distributional cited requirements of the Bankruptcy Act [predecessor to the Bankruptcy Code].” In re Faber’s, Inc., 360 F. Supp. 946, 949 (D. Conn. 1973). See, e.g., Int’l Bhd. of Teamsters, AFL-CIO v. Kitty Hawk Int’l, Inc. (In re Kitty Hawk, Inc.), 255 B.R. 428, 439 (Bankr. N.D. Tex. 2000) (“Although the nature of a creditor’s claim is determined under state law, the [Bankruptcy] Code establishes the priorities of claims. . . . Where a state statute would alter the priority of claims in a bankruptcy case, the state statute is preempted by the Code.”) (holding that Michigan statute providing employees with a preference over other general unsecured creditors is preempted by Bankruptcy Code sections 507 and 1113); In re Lull Corp., 162 B.R. 234, 240 (Bankr. D. Minn. 1993) (“A state statute cannot reset bankruptcy priorities.”) (holding that Minnesota statute allowing workers’ compensation fund to have the same priority accorded to employee wages is preempted by section 507). 342 Section 545 provides, in relevant part, that “[t]he trustee may avoid the fixing of a statutory lien on property of the debtor” under certain conditions. 11 U.S.C. § 545. One bankruptcy court explained that the provisions from which section 545 derived were “intended to prevent state laws which prioritized liens on the happening of insolvency from undercutting federal bankruptcy laws.” Davis v. IRS, 22 B.R. 523, 525 (Bankr. W.D. Pa. 1981). For cases upholding state law provisions under section 545, see In re Merchs. Grain, Inc., 93 F.3d 1347, 1358 (7th Cir. 1996), cert. denied, 519 U.S. 1111 (1997) (Ohio statute creating lien upon delivery of grain is not avoidable under section 545); In re Anchorage Int’l Inn, Inc., 718 F.2d 1446, 1452 (9th Cir. 1983) (Alaska statute requiring proceeds of sale of a liquor license to be used first to pay creditors holding debts related to the liquor licensed business creates valid lien); In re Nicolls, 384 B.R. 113, 122 (Bankr. W.D. Pa. 2008) (Indiana statute creating hospital lien in favor of patient with judgment against tortfeasor for injuries requiring medical case creates valid lien). For cases striking down and refusing to enforce state law provisions, see Perez v. Campbell, 402 U.S. 637, 652 (1971) (Arizona statute that suspended driving privileges unless, among other things, motorist subject to judgment posted security sufficient to satisfy judgment, even if judgment claim was discharged in bankruptcy is invalid); In re Universal Trend, Inc., 114 B.R. 936, 938 (Bankr. N.D. Ohio 1990) (Ohio statute that establishes statutory trust in favor of employees is preempted by employees’ bankruptcy rights and thus invalid, and does not prevent any such trust funds from being withheld as property of the estate). 343 One court explained that to withstand scrutiny, “the state law must attend to the realities and technicalities of the property rights created, or else those rights will be dismissed as disguised priorities under the Bankruptcy Code.” In re Universal Trend, Inc., 114 B.R. 936, 938 (Bankr. N.D. Ohio 1990) (“The Bankruptcy Code often takes account of property rights which are determined by state law, as for example, the perfection of security interests and exempt property of the Debtor. Nonetheless, the state law must attend to the realities and technicalities of the property rights created, or else those rights will be dismissed as disguised priorities under the Bankruptcy Code.”) (quoting In re Davis, 13 B.R. 456, 460 (Bankr. S.D. Ohio 1980)). “Statutory enactments may operate to create trust funds in favor of certain specified persons. . . . However, such trusts must stand the tests of being termed disguised priorities in violation of section 507 or statutory liens avoidable under section 545.” Id. at 940 (citations omitted). See also In re Anchorage Int’l Inn, Inc., 718 F.2d 1446, 1450 n. 3 (9th Cir. 1983) (“[W]hen a state-created entitlement is enforceable inside and outside bankruptcy, ‘there is no reason stemming from the justifications underlying condemnation of state-created priorities . . . to refuse recognition of the entitlement’ in the bankruptcy situation.”) (citations omitted). IV. Proposed Recommendations: Commencing the Case  American Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 98 of 402 Bankruptcy Institute 2. Wage and Benefits Priorities Recommended Principles: Section 507(a)(4) and (5) of the Bankruptcy Code should be combined to create a single priority in an aggregate amount of $25,000 per employee, without an earnings period limit, for the kinds of prepetition employee compensation and benefit plan claims identified in the current section  507(a)(4) and (5). To the extent that the aggregate limit is insufficient to meet all such obligations, the current prepetition priority order — wages and other compensation as identified in section 507(a)(4), followed by employee benefit plan contributions as described in section 507(a)(5) — should continue to be observed in applying the combined, aggregate priority. As under current law, the amount of this aggregate per-employee priority should be increased based on the Consumer Price Index for All Urban Consumers under section 104(a). In addition, section 549 should be amended to permit the trustee to pay prepetition employee wages, other compensation, and benefit plan contributions up to the peremployee priority limit without requiring the filing of a motion or order of the court, although the trustee should provide notice of such payments to be made. Authority for payments in excess of the priority cap should continue to be requested by motion. 16 1, 20 ber 2 vem n No ed o rchiv 63 a -353 . 14 Wage and Benefits Priorities: Background , No rown B h v. xset Employees are the heartdof many businesses. They make the debtor’s product, service its customers, n Bli i cite and innovate, manage, and generate value. Although some commentators view employees as liabilities, in many industries, the success of a business often relates directly to the commitment and efforts of its employees. Employees, in turn, frequently depend on timely payments from their employers for their livelihood and subsistence. As observed by one court: “The bankruptcy act, while primarily intended to secure an equal distribution of the assets of the bankrupt among his creditors, evinces a strong intent on the part of Congress to protect those who are dependent on their daily earnings for their support.”344 In this respect, employees arguably differ from other creditors who either may have other revenue sources in addition to payments owed and made by the debtor, or may have a greater capacity to perform diligence on the debtor to negotiate for stronger contractual protections and leverage.345 344 See In re Caldwell, 164 F. 515 (E.D. Ark. 1908). 345 See Lucian Arye Bebchuk & Jesse M. Fried, The Uneasy Case for the Priority of Secured Claims in Bankruptcy, 105 Yale L.J. 857, 885 (1996); Elizabeth Warren & Jay Lawrence Westbrook, Contracting Out of Bankruptcy: An Empirical Intervention, 118 Harv. L. Rev. 1197, 1232 (2005). Professors Warren and Westbrook explain: The substantial sophistication and the high transaction costs required to obtain the necessary information present significant barriers. Moreover, the costs of moving from one employer to another can be quite onerous. . . . Similarly, although most creditors have the option of spreading their risks by extending credit to several customers, this option is not available to employees, who are unlikely to work for more than a single employer. Id.  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID:ABI Commission to Study the Reformof 402 10211115, DktEntry: 37-2, Page 99 of Chapter  Priority treatment for wage claims under U.S. bankruptcy laws has a long history.346 Their priority was clearly articulated in the short-lived 1841 Act, and was included and refined in the laws that followed. Such priority was initially limited to certain kinds of employees, but more recent laws have focused on limiting this priority based on (i) when the wages were earned and (ii) the amount of wages earned.347 The Bankruptcy Code has continued this model in two sections: section 507(a)(4) provides a priority for wages and other compensation up to $11,725 per employee earned by the employee during 180 days before the earlier of the petition date or the date of the cessation of the debtor’s business; and section 507(a)(5) provides a priority for employer contributions to employee benefit plans for services provided during 180 days before the earlier of the petition date or the date of the cessation of the debtor’s business in an aggregate amount of $11,725, multiplied by the number of covered employees less any amounts paid to such employees under section 507(a)(4). Wage and Benefits Priorities: Recommendations and Findings Congress added section 507(a)(5) to address a split in the case law about whether the “wage” priority covered contributions to certain kinds of employee benefit plans.348 The language of section 507(a) (5) clarified this point, but courts, debtors, and employees have continued to struggle with the application of section 507(a)(4) and (5) priorities. Common issues include: (i) whether the section 16 1, 0 507(a)(5) priority imposes an aggregate or per-employee cap,349 andr (ii) 2 be 2 whether the mandatory vem n No offset of the section 507(a)(4) “wage priority” against the section 507(a)(5) “benefit plan priority” ed o hiv results in often inadequate protection for the 35363 arc The latter issue also causes calculation and employee. 14 administrative issues for debtorsrown, Nperhaps more importantly, substantial hardship for many and, o. .B eth v employees. Blixs in cited The Commissioners articulated various ways to restructure the wage and employee benefits priorities. As a conceptual matter, the Commission determined that one overall monetary cap covering both wages and employee benefit plan contributions on a per-employee basis was consistent with the historical development of these priorities and achieved a fair result. It also determined that the base aggregate cap should be raised to $25,000 per employee, with that amount being applied first toward wage claims and second toward employee benefit plan contributions, in the event that such cap is insufficient to satisfy all covered claims. Finally, the Commissioners discussed the common practice by debtors in possession350 of filing a first-day motion requesting authority to pay employee wages and benefit plan contribution claims, typically on the ground that such claims are entitled to priority treatment under section 507. Such 346 See Ex Parte Steiner, 22 F. Cas. 1234 (C.C.E.D. Pa. 1842) (No. 13,354) (interpreting wage priority under the 1841 Bankruptcy Act). 347 For example, section 64(b) of the 1898 Bankruptcy Act provided fourth priority to “wages due to workmen, clerks, or servants which have been earned within three months before the date of the commencement of proceedings, not to exceed three hundred dollars to each claimant.” Bankruptcy Act of 1898, 30 Stat. 544, 563, c. 541 (Comp. St. § 9648). 348 See, e.g., Howard Delivery Serv., Inc. v. Zurich Am. Ins. Co., 547 U.S. 651, 658–60 (2006). 349 See In re Consol. Freightways Corp. of Del., 363 B.R. 110, 123 (Bankr. C.D. Cal. 2007), aff ’d in part, rev’d in part, 564 F.3d 1161 (9th Cir. 2009) (discussing different approaches to calculating the section 507(a)(5) priority cap). 350 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. IV. Proposed Recommendations: Commencing the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 100 of 402 Bankruptcy Institute motions and the attendant responsive pleadings, hearings, and orders unnecessarily consume both debtor and judicial resources and can delay the debtors’ normal payroll cycles, even though these motions are often noncontroversial and ultimately granted by the court. Many courts, debtors, and commentators recognize the value to the debtor of receiving uninterrupted service from its employees. Accordingly, the Commission recommended that section 549 of the Bankruptcy Code be amended to allow the debtor in possession to pay wage priority and benefit plan priority claims up to the proposed per-employee priority cap, pursuant to section 507(a)(4) and (5) without an order of the court, provided that the debtor files a notice of the amount of such proposed payments. E. Financial Contracts, Derivatives and Safe Harbor Provisions The filing of a chapter 11 case typically effects an automatic stay of, among other things, all prepetition collection efforts against the debtor, its property, and property of the estate.351 In addition, counterparties to many prepetition executory contracts with the debtor cannot unilaterally terminate their contracts or otherwise affect the debtor’s rights under such contracts, and the trustee may avoid prepetition fraudulent and preferential transfers.352 The Bankruptcy Code, however,6exempts certain 1 1, 20 kinds of financial contracts from these and certain other bankruptcyvprovisions. These exemptions ber 2 m No e generally cover financial contracts qualifying as a securities hived on commodities contract, forward contract, arc contract, repurchase agreement, swap agreement,-or 363 35 master netting agreement (collectively referred o. 14 to as “qualified financial contracts”)..353rown, N B hv xset n Bli di ci the The protections underte Bankruptcy Code for qualified financial contracts — commonly referred to as “safe harbors” — find their origins in sections 362(b)(6) and 746(c) of the Bankruptcy Code, which were both included in the 1978 version of the Bankruptcy Code to promote stability in the commodities market.354 Congress built on this concept in 1982 by adding certain kinds of securities contracts to the exemptions and enhancing the protections afforded to those contracts (it also replaced section 746(c) with section 546(e)).355 Similar to the original legislation, Congress identified market stability as the primary purpose underlying these amendments: “[C]ertain protections are 351 11 U.S.C. § 362(a). 352 Id. §§ 365, 547, 548. 353 Id. §§ 362(b)(27), 546(e)–(g), (j), 555, 556, 559, 560, 561, 562. Each of these terms is defined in section 101 or 741 of the Bankruptcy Code. Id. §§ 101, 741. Steven L. Schwarcz, Derivatives and Collateral: Balancing Remedies and Systemic Risk, 2015 Ill. L. Rev.__, at *1–2 (forthcoming 2015) (“Bankruptcy law in the United States provides unique protections to creditors in derivatives transactions. Unlike other creditors of a debtor, derivatives counterparties have special rights and immunities in the bankruptcy process, including virtually unlimited enforcement rights against the debtor (the ‘safe harbor’). The safe harbor’s articulated justification is that it is necessary to protect against systemic risk — the risk that an event will trigger a loss of economic value or confidence in a substantial segment of the financial system that is serious enough to have significant adverse effects on the real economy.”), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2419460. 354 S. Rep. No. 95-989, at 8 (1978), reprinted in 1978 U.S.C.C.A.N. 5787. 355 The legislative history provides, in relevant part: The resulting discrimination in treatment [between commodities and securities] appears to have been inadvertent. It plainly is not supportable on policy grounds. It is further the Commission’s view that the amendments now under consideration present an effective solution to these problems by assuring equality of treatment as between the securities and commodities industries. Bankruptcy of Commodity and Securities Brokers: Hearings before the Subcomm. on Monopolies and Commercial Law of the H. Comm. on the Judiciary, 97th Cong. 239 (1981) (testimony of Bevis Longstreth, Comm’r, Sec. & Exch. Comm’n).  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 101 of 402 ABI Commission to Study the Reform of Chapter  necessary to prevent the insolvency of one commodity or securities firm from spreading to other firms and [possibly] threatening the collapse of the affected market.”356 Congress further expanded the safe harbors in 1982, 1990, 1994, 2005, and 2006.357 Some commentators argue that these amendments expanded the safe harbors well beyond their original purpose and now impede a debtor’s reorganization efforts to the detriment of other stakeholders.358 The Commission considered the important role that the safe harbors play in financial markets and carefully balanced the competing concerns throughout its deliberations. As described below, the Commission recommended certain targeted amendments to the safe harbors that continue protections for qualified financial contracts in appropriate circumstances, but reduce opportunities for manipulation or abuse. 1. Scope of Section 546(e) Safe Harbors Recommended Principles: Section 546(e) of the Bankruptcy Code should be amended to remove protection from avoidance actions for beneficial owners of privately issued securities in connection with prepetition transactions using some or all of the debtor’s assets to facilitate the transaction (e.g., leveraged buyouts). 16 1, 20 er 2 emb Novfrom avoidance actions for Section 546(e) should continue the existing protection on ived arch conduits in both public and private (i) securities industries participants3who act as 5363 . 14Nopublic securities holders. securities transactions andn(ii) w , . Bro eth v ixs in Bl Sectionte546(e) and the parallel provisions of section 546 applicable to other ci d qualified financial contracts should continue to exclude from the safe harbors transfers made with actual intent to hinder, delay, or defraud, and such transfers should remain voidable under section 548(a)(1)(A). The exclusion from the safe harbors for transfers made with actual intent to hinder, delay, or defraud should also apply to transfers made with similar intent that are 356 H.R. Rep. No. 97-420, at 1 (1982), reprinted in 1982 U.S.C.C.A.N. 583, 583. For a review of the justifications for and impact of the bankruptcy safe harbors, see Schwarcz, Derivatives and Collateral, supra note 353, at *4–5 (“The purpose of the safe harbor is to help ensure that large derivatives dealers can enforce their remedies against a failed counterparty, thereby minimizing the dealer’s losses and reducing its chances of collapse. There are however, at least three possible flaws in that logic. The first flaw is that if a dealer itself is a defaulting counterparty, the safe harbor enables the dealer’s other counterparties to enforce their remedies, thereby hastening the dealer’s collapse. This occurred, for example, in the case of [Lehman Brothers]. The second flaw is that there is ‘little actual evidence to support’ the claim that the collapse of a dealer might systemically disrupt the derivatives market. . . . [Lastly], the safe harbor itself appears to incentivize market concentration by enabling dealers and other parties to virtually ignore counterparty risk. . . . For this reason, creditors ‘are not overly concerned with their debtor’s financial stability, because they protect themselves with the debtor’s collateral, rather than with their understanding of the firm itself.’”). 357 For a review of the history of the safe harbors, see Charles W. Mooney, The Bankruptcy Code’s Safe Harbors for Settlement Payments and Securities Contracts: When is Safe Too Safe?, 49 Tex. Int’l L.J. 243, 245–50 (2014); Stephen J. Lubben, Systemic Risk & Chapter 11, 82 Temp. L. Rev. 433 (2009); Edward R. Morrison & Joerg Riegel, Financial Contracts and the New Bankruptcy Code: Insulating Markets from Bankrupt Debtors and Bankruptcy Judges, 13 Am. Bankr. Inst. L. Rev. 641 (2006). See generally Eleanor Heard Gilbrane, Testing the Bankruptcy Code Safe Harbors in the Current Financial Crisis, 18 Am. Bankr. Inst. L. Rev. 241 (2010) (discussing legislative history of safe harbor provisions and amendments thereto). 358 See, e.g., Stephen J. Lubben, Repeal the Safe Harbors, 18 Am. Bankr. Inst. L. Rev. 319 (2010); Frank Partnoy & David A. Skeel, Jr., The Promise and Perils of Credit Derivatives, 75 U. Cin. L. Rev. 1019 (2007); Franklin R. Edwards & Edward R. Morrison, Derivatives and the Bankruptcy Code: Why the Special Treatment?, 22 Yale J. on Reg. 91 (2005). IV. Proposed Recommendations: Commencing the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 102 of 402 Bankruptcy Institute voidable under applicable state fraudulent transfer or conveyance laws avoidable by the trustee under section 544(b). o For purposes of this principle, a publicly issued security should include a security of a debtor or its affiliate that is registered under section 12 of the Securities Exchange Act of 1934 (15 U.S.C. § 78l) or sold in reliance on Rule 144A or Regulation S under the Securities Act of 1933 (15 U.S.C. § 77a et seq.). Scope of Section 546(e) Safe Harbors: Background Section 546(e) of the Bankruptcy Code protects certain types of transactions from avoidance by the trustee359 under sections 544, 545, 547, 548(a)(1)(B) and 548(b). (These sections generally allow the trustee to avoid, among other things, prepetition fraudulent or preferential transfers, as well as unperfected securities interests, and to recover the value of those transfers for the benefit of the estate.) Specifically, a trustee may not avoid a margin payment or settlement payment made by, to, or for the benefit of a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency. In addition, similar protection applies to transfers made by, to, or for the benefit of any of these parties in connection with a securities contract. 16 1, 20 2 A “settlement payment” is defined in section 741(8) of the Bankruptcy rCode as a “preliminary mbe Nove settlement payment, a partial settlement payment, an interimon ived settlement payment, a settlement arch 363 payment on account, a final settlement payment, 5 any other similar payment commonly used -3 or o. 14 360 n, N in the securities trade.” Courts haverow B interpreted the term to include many kinds of transactions th v. lixse legislative intent to insulate the securities transfer system from arguably not within the original in B cited fraudulent conveyance and preference action. For example, courts have protected transfers to the beneficial holders of privately issued securities in leveraged buyouts that arguably have no impact on the securities transfer system.361 Some commentators also question whether the provision should protect the beneficial owners of publicly held securities or, rather, should be limited solely to securities industries participants who act as conduits in both public and private securities transactions.362 359 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. 360 11 U.S.C. § 741. 361 Courts originally limited application of section 546(e) in the fraudulent transfer context to conduits and the beneficial owners of publicly held securities; they did not protect the beneficial owners of privately issued securities. See, e.g., Jewel Recovery, L.P. v. Gordon, 196 B.R. 348, 353 (N.D. Tex. 1996); Kapila v. Espirito Santo Bank (In re Bankest Capital Corp.), 374 B.R. 333, 346 (Bankr. S.D. Fla. 2007); Official Comm. of Unsecured Creditors v. Lattman (In re Norstan Apparel Shops, Inc.), 367 B.R. 68, 77 (Bankr. E.D.N.Y. 2007). Nevertheless, the Third, Sixth, and Eighth Circuit Courts have held that beneficial owners of both publicly and privately held securities are protected. See, e.g., Contemporary Indus. Corp. v. Frost, 564 F.3d 981 (8th Cir. 2009); QSI Holdings, Inc. v. Alford (In re QSI Holdings, Inc.), 571 F.3d 545 (6th Cir. 2009), cert. denied, 558 U.S. 1148 (2010); Brandt v. B.A. Capital Co. (In re Plassein Int’l Corp.), 590 F.3d 252 (3d Cir. 2009), cert. denied, 559 U.S. 1093 (2010). 362 For a discussion of related approaches to limiting the scope of section 546(e), see, e.g., Samir D. Parikh, Saving Fraudulent Transfer Law, 86 Am. Bankr. L.J. 305, 344 n. 225 (2012) (“Another basis for narrowing the scope of section 546(e) has been termed the ‘mere conduit’ argument. The argument was introduced by the Eleventh Circuit Court of Appeals in Munford v. Valuation Research Corp. (In re Munford, Inc.), 98 F.3d 604 (11th Cir. 1996), cert. denied, 522 U.S. 1068 (1998). In Munford, the settlement payments at issue were made to a recognized financial institution. But the court held that the financial institution ‘was nothing more than an intermediary or conduit’ because it did not acquire a beneficial interest in the funds. The court reasoned that since the financial institution ‘never acquired a beneficial interest in either the funds or the shares,’ it was not a ‘transferee’ as that term is used in the Bankruptcy Code, and section 546(e) was inapplicable. The argument has been roundly criticized, and it is unclear if any other court has relied on this rationale in narrowing section 546(e)’s exemption. The deficiency in the ‘mere conduit’ argument is that section 546(e) in no way requires that the financial institution to which or from which payments were made or received acquire a ‘beneficial interest’ in the funds. Financial institutions involved in securities transactions rarely  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 103 of 402 ABI Commission to Study the Reform of Chapter  Scope of Section 546(e) Safe Harbors: Recommendations and Findings As written and applied, the section 546(e) safe harbor has insulated settlement payments to the ultimate beneficiaries of leveraged buyouts (“LBOs”) and similar transactions, even if the securities were privately issued. Absent the safe harbors, these payments would be potentially voidable as fraudulent transfers. This outcome appears anomalous in light of the policy underlying section 546(e): to insulate the securities transfer system from fraudulent conveyance and preference actions. The Commission reviewed the development of section 546(e) under both the Bankruptcy Code and the case law. They noted the uncertainty in the courts’ interpretations of the term “settlement payment” and suggested that similar issues may arise with respect to the term “transfers . . . in connection with a securities contract,” which was added by the BAPCPA Amendments. The Commissioners discussed how to balance the expectations of the financial markets with the need to protect the debtor’s estate and other stakeholders from prepetition transfers that (i) do not affect secondary markets and (ii) constitute preferences or fraudulent transfers under bankruptcy law or applicable state law. The Commissioners evaluated the different types of transactions that may be protected by the section 546(e) safe harbor and noted the particular imbalance in LBOs involving privately issued securities. As explained by the Honorable Christopher S. Sontchi of the U.S. Bankruptcy Court for the District of Delaware during his testimony before the House Judiciary Committee’s Subcommittee on Regulatory 16 Reform, Commercial and Antitrust Law: 1, 20 r2 mbe No harbor has insulated from As written and applied, however, the section 546(e) nsafeve do chive ultimate beneficial recipients of a preference and fraudulent conveyance 5363 ar the actions 3 . 14- in private transactions. The result has been to settlement payments, including, insiders No own v. Br of bankrupt companies with an almost “too good to be provide officers andedirectors h ixs t in Bl ed to preference and fraudulent conveyance actions.363 true” defense cit In these instances, the Commissioners found it difficult to reconcile the protections that courts were affording the beneficial owners of privately issued securities with the original purpose of the legislation. The Commissioners were most troubled by situations involving prepetition transfers in connection with an LBO that leaves the debtor with insufficient capital and that is attributable, at least in part, to bad faith on the part of the debtor’s insiders. Absent the section 546(e) safe harbor that has been extended to LBO transactions, the debtor in possession could challenge such a prepetition transfer as a fraudulent transfer364 and possibly avoid it for the benefit of the estate and other stakeholders harmed by the depletion in the debtor’s value. Nevertheless, section 546(e) prevents the debtor in possession from bringing fraudulent transfer claims, even against insiders of the debtor, unless the transfer was made within two years before bankruptcy and with actual intent to hinder, delay, or defraud creditors. In balancing the competing considerations in the LBO context, the Commissioners discussed the need to continue to protect securities industries participants that act as conduits in prepetition transfers. The acquire a beneficial interest in the funds that they handle. The ‘mere conduit’ argument is an outlier in the debate regarding section 546(e).” Id. at 609–10 (citations omitted). 363 Exploring Chapter 11 Reform: Corporate and Financial Institution Insolvencies; Treatment of Derivatives, Hearing Before the H. Subcomm. on Regulatory Reform, Commercial and Antitrust Law, 113th Cong. 12 (2014) (statement of the Honorable Christopher S. Sontchi, U.S. Bankruptcy Judge for the District of Delaware). 364 A fraudulent transfer generally involves a transfer of a company’s assets for less than reasonably equivalent value at a time that the debtor is insolvent or is rendered insolvent by the transfer (a “constructively fraudulent transfer”). IV. Proposed Recommendations: Commencing the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 104 of 402 Bankruptcy Institute Commissioners noted that the beneficial owner of the privately issued securities should be deemed the initial transferee for purposes of fraudulent transfer law, and that conduits should not be affected by any limited change to section 546(e) in this respect. The Commission agreed, however, that conduits should be expressly covered by section 546(e) to avoid any uncertainty that might implicate the financial markets. The Commission likewise considered the merits of limiting section 546(e) solely to securities industries participants that act as conduits, but ultimately it determined that allowing fraudulent transfer claims against the beneficial owners of publicly issued securities would have the potential to affect the securities transfer system — a considerable difference from privately issued securities transfers. The Commissioners explored whether they could strike a reasonable compromise by limiting the protections of the section 546(e) safe harbor to beneficial holders of publicly issued securities that received the transfers in good faith. The Commission generally agreed that the good faith standard could align with the objectives of both the safe harbor and fraudulent transfer law, but it acknowledged the difficulty in administering and litigating such a standard. Some of the Commissioners strongly believed that application of the good faith standard and the attendant challenges posed by distinguishing good faith transactions from bad faith transactions could create substantial uncertainty in the markets. Accordingly, the Commission voted to maintain the safe harbor protections for publicly issued securities, without any good faith qualification. Another issue that arises with respect to the section 546(e) safe harbor is whether its protections are limited to fraudulent transfer actions under section 548 of the Bankruptcy Code or whether they also 16 extend to such actions under state law that are avoidable by the trustee under ,section 544(b) of the 1 20 ber 2 Bankruptcy Code or avoidable by a litigation trust or individual creditors em confirmation of a chapter Nov after d on chive purports to limit the trustee’s ability 11 plan. The courts are split on this issue. Even though6therstatute 3a 353 . 14to bring avoidance actions, some courts have o , N extended the protection to preclude state law causes of own 365 v. Br actions. Other courts have heldth e that “there is no statutory text making section 546(e) applicable to Blixs claims brought on behalf of individual creditors, or displacing their state law rights, by plain meaning ed in cit analysis or otherwise.”366 The Commission evaluated each of these positions and discussed the practical consequences of allowing state law actions to proceed while precluding federal causes of action brought by the trustee on behalf of the estate. Ultimately, the Commission concluded that the exclusion from the safe harbors for transfers made with actual intent to hinder, delay, or defraud should apply whether the action is brought under federal or state law. Thus, the trustee will be able to avoid an actual intent fraudulent transfer whether brought under section 544(b) or 548. The Commission was not able to reach a consensus on extending the protections of the section 546(e) safe harbor to actions outside a federal bankruptcy case. Notably, the Commission’s recommended principles on section 546(e) concentrate largely on prepetition transactions in which some or all of the debtor’s assets are being used to facilitate the transaction (e.g., LBOs). Except as otherwise specifically discussed in this Report, the Commission does not recommend reducing the coverage of section 546(e) for securities purchases and sales, securities options, securities loans, margin loans, and other transfers and transactions that are currently protected by section 546(e). 365 See Whyte v. Barclays Bank PLC, 494 B.R. 196 (S.D.N.Y. 2013). 366 Weisfelner v. Fund 1 (In re Lyondell Chem. Co.), 503 B.R. 348 (Bankr. S.D.N.Y. 2014). See also In re Tribune Co. Fraudulent Conveyance Litig., 499 B.R. 310 (S.D.N.Y. 2013).  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 105 of 402 ABI Commission to Study the Reform of Chapter  2. Treatment of Repurchase Agreements Under Safe Harbors Recommended Principles: The safe harbor for repurchase agreements should be narrowed as a means to foster financial stability, reduce interconnectedness, and exclude disguised financing arrangements. o As a preferred option, the safe harbors for repurchase agreements should be limited to the kinds of agreements included in the pre-BAPCPA definitions of “repurchase agreement” in section 101(47) and “securities contract” in section 741(7) of the Bankruptcy Code. o Alternatively, at a minimum, the safe harbors for repurchase agreements should be amended to exclude repurchase agreements that are, in essence, committed financing arrangements for mortgage loan portfolios. Specifically, the definitions of “repurchase agreement” in section 101(47) and “securities contract” in section 741(7) should be amended to exclude repurchase agreement facilities that have the economic attributes of traditional mortgage warehouse facilities, which typically are more akin to committed secured financing arrangements than, 2016 repurchase true 1 ber 2 agreements. ovem Treatment N d on chive 3 ar 3536 . 14, No own v. Br eth Blixs ofciRepurchase Agreements Under Safe Harbors: ed in t Background Sections 555 and 559 of the Bankruptcy Code allow certain parties, including financial institutions and financial participants, to liquidate, terminate, or accelerate a securities contract or repurchase agreement without relief from the automatic stay of section 362 or concern for the prohibition on enforcement of ipso facto clauses in section 365(e) of the Bankruptcy Code.367 In addition, the automatic stay generally does not apply to setoffs and the exercise of other remedies by the nondebtor party under a repurchase agreement.368 Section 559 was added to the Bankruptcy Code in 1984 to treat repurchase agreements the same as commodities and securities contracts under the safe harbors, in large part to protect the financing of the national debt.369 367 11 U.S.C. §§ 555, 559. 368 Id. § 362(b)(7). 369 See 5 Collier on Bankruptcy ¶ 559.LH (“The effective functioning of the repo market can only be assured if repo investors will be protected against open-ended market loss arising from the insolvency of a dealer or other counterparty in the repo market. The repo market is as complex as it is crucial. It is built upon transactions that are highly interrelated. A collapse of one institution involved in repo transactions could start a chain reaction, putting at risk hundreds of billions of dollars and threatening the solvency of many additional institutions. Since the repo market is important to the health of the country’s financial system, it is desirable that the Code be interpreted and implemented in a manner which protects that market without creating an unfair result for debtors. . . . The proposed amendments will take an important first step toward meeting the full objective of Public Law 97-222 by expressly providing that similar protections apply to the crucial portions of the repo market involving U.S. Government and agency obligations, certificates of deposit, and eligible bankers’ acceptances. The structure of the proposed amendments is based upon the addition to the Code of new definitions of ‘repo participant’ and ‘repurchase agreement’ and the making of conforming changes in relevant provisions of the Code. The proposed amendments are intended to afford participants in the repo market the same treatment with respect to the stay and avoidance provisions of the Code that Public Law 97-222 explicitly provided stockbrokers, securities clearing agencies, commodity brokers and forward contract merchants in connection with securities contracts, commodity contracts and forward contracts.”) (citations omitted). IV. Proposed Recommendations: Commencing the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 106 of 402 Bankruptcy Institute In 2005, pursuant to the BAPCPA Amendments, Congress amended the scope of sections 555 and 559 by expanding the definitions of “securities contracts” and “repurchase agreements” and adding “financial participants” to the list of protected parties under these sections.370 Specifically, Congress added mortgage loans and any interests in mortgage loans, including repurchase transactions, to the definition of securities contracts in section 741(7) of the Bankruptcy Code.371 Similarly, it added mortgage-related securities, mortgage loans, and interests in mortgage-related securities or mortgage loans, to the definition of repurchase agreements in section 101(47) of the Bankruptcy Code.372 It also defined financial participant as “an entity with at least $1 billion in notional or principal amount outstanding or $100 million in mark-to-market securities contracts, commodities contracts, swap agreements, repurchase agreements, or forward contracts, with the debtor at the time of filing or on any day during the fifteen-month period preceding filing.”373 Some commentators have questioned whether the expanded definitions of securities contracts and repurchase agreements further the underlying policies of the safe harbors.374 For example, a committed mortgage loan repurchase agreement facility can function similarly to a conventional secured mortgage warehouse facility, but arguably qualify for protections under the safe harbors. In a typical mortgage warehouse transaction, the loan originator obtains short-term financing from a lender through a credit facility or similar arrangement secured by a pledge of mortgages or other assets owned by the originator (often to provide short-term financing until the mortgages can be deposited into a securitization pool). The originator can transfer or sell the mortgages or 16 assets and would typically use any proceeds to pay down the facility with ber 2lender.375 Such secured the 1, 20 vem transactions do not, however, present the same contagion or marketorisks posed by true repurchase nN ed o iv agreements and arguably fall outside the scope of the 63 arch safe harbors. 53 -3 o. 14 n, N row Moreover, commentators robustlyh v. B the ongoing utility of safe harbors for repurchase agreements t debate lixse in B covering mortgage loansdand nonagency mortgage-backed securities. Some commentators argue that cite mortgage loan repurchase agreements should no longer be protected by the safe harbors.376 These commentators have called for excluding mortgage interests and mortgage-related transactions from the definitions of repurchase agreements and securities agreements. They assert, among other things, that mortgages are illiquid assets and therefore fall outside the justification for safe harbor protection (i.e., “preservation of the liquidity of investments”).377 Others support maintaining broad protection for repurchase agreements, including mortgage repurchase agreements, based on the interconnectedness of the markets and the increasing importance of repurchase agreements in both domestic and global 370 371 372 373 374 See id. 11 U.S.C. § 741(7). Id § 101(47). Id § 101(22A). See also Mooney, supra note 357, at 249. See, e.g., Calyon N.Y. Branch v. Am. Home Mortg. Corp. (In re Am. Home Mortg., Inc.), 379 B.R. 503 (Bankr. D. Del. 2008). See also Mooney, supra note 357, at 251–52. 375 These secured transactions are to be contrasted with repurchase agreements, which typically involve two agreements: first, the originator sells its mortgages or other assets to the lender in exchange for funds; second, the originator agrees to repurchase the mortgages or other assets for the original price plus a premium at a date certain (usually one year after the original sale). 376 See, e.g., Edward R. Morrison et al., Rolling Bank the Repo Safe Harbors, 69 Bus. Law. 1015, 1019 (2014) (proposing to “scal[e] back the repo safe harbor to approximately the 1984 scope for ‘repurchase agreements’, namely, safe harboring only repos on U.S. Treasury and Agency securities backed by the government’s full faith and credit, certificates of deposits, and bankers acceptances”). 377 Exploring Chapter 11 Reform: Corporate and Financial Institution Insolvencies; Treatment of Derivatives, Hearing Before the H. Subcomm. on Regulatory Reform, Commercial and Antitrust Law, 113th Cong. 9 (2014) (statement of the Honorable Christopher S. Sontchi, U.S. Bankruptcy Judge for the District of Delaware). Judge Sontchi also explained: “The current safe harbors for repurchase agreements allow for ‘runs’ on financial institutions such as American Home Mortgage by counterparties/lenders which are not subject to the automatic stay and, thus, are free to terminate repos and other financial contracts en masse.” Id. at 10.  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 107 of 402 ABI Commission to Study the Reform of Chapter  investment portfolios.378 With respect to repurchase agreements specifically, these supporters believe that the protections afforded to such contracts by the safe harbors reduce the cost of credit and support domestic real estate markets.379 These supporters also suggest that any restrictions on investment in mortgage loans by financial institutions are best implemented through carefully considered prudential regulation rather than through the “blunt instrument” of a change to the Bankruptcy Code’s safe harbors. Both sides rely on anecdotal evidence to support their respective positions. Treatment of Repurchase Agreements Under Safe Harbors: Recommendations and Findings Repurchase agreements as financial instruments provide liquidity and flexibility to market participants. They also represent a large component of the financial markets.380 The Commissioners recognized the important role that repurchase agreements play in the markets, particularly those initiated on an overnight or short-term basis. Some of the Commissioners agreed with those commentators who distinguish mortgage loan repurchase agreements from other kinds of repurchase agreements structured around more liquid assets such as U.S. government and agency securities. The ability to liquidate the transferred assets immediately upon a default is a central and important feature of traditional repurchase agreements. The Commissioners discussed the advantages and disadvantages of providing safe harbor protections 016 to mortgage loan repurchase agreements and recognized the challenges r 21, 2 beto reducing these protections. em Some of the Commissioners believed that the risks posed on Nov by removing mortgage loan repurchase ed rchiv agreements from the safe harbors were significantly outweighed by the potential benefits. These 63 a -353 14 Commissioners were persuaded by n, No. the arguments that inclusion of these repurchase agreements row v. B encouraged runs on debtorthoriginators and accelerated (rather than reduced) contagion.381 The xse n Bli i cite Commission voteddto scale back the safe harbors for repurchase agreements to the pre-BAPCPA definitions of repurchase agreement and securities contract.382 378 See Steven L. Schwarcz & Ori Sharon, The Bankruptcy-Law Safe Harbor for Derivatives: A Path-Dependence Analysis, 71 Wash. & Lee L. Rev. 1715 (2014). 379 See, e.g., Exploring Chapter 11 Reform: Corporate and Financial Institution Insolvencies; Treatment of Derivatives, Hearing Before the H. Subcomm. on Regulatory Reform, Commercial and Antitrust Law, 113th Cong. 35 (2014) (statement of Seth Grosshandler, Partner at Cleary, Gottlieb, Steen & Hamilton LLP) (“In particular, the safe harbor for repurchase agreements on residential mortgage-backed securities and whole loan mortgages serves to reduce the cost of mortgage financing to homeowners.”). 380 Data as of June 2014 suggest that the value of outstanding repurchase agreements in the United States is approximately $4 trillion. See Elizabeth Holmquist & Josh Gallin, Repurchase Agreements in Financial Accounts of the United States, June 30, 2014, available at http://www.federalreserve.gov/econresdata/notes/feds-notes/2014/repurchase-agreements-in-the-financialaccounts-of-the-united-states-20140630.html. 381 See Morrison, et al., Rolling Back the Repo Safe Harbors, supra note 376, at 1017 (discussing safe harbors for repurchase agreements and observing that “there is little evidence that they serve this purpose”). “Instead, considerable evidence shows that, when they matter most — in a financial crisis — the safe harbors exacerbate the crisis, weaken critical financial institutions, destabilize financial markets, and then prove costly to the real economy.” Id. For a general discussion of these issues, see Schwarcz, Derivatives and Collateral, supra note 353, at *4–5 (“The purpose of the safe harbor is to help ensure that large derivatives dealers can enforce their remedies against a failed counterparty, thereby minimizing the dealer’s losses and reducing its chances of collapse. There are however, at least three possible flaws in that logic. The first flaw is that if a dealer itself is a defaulting counterparty, the safe harbor enables the dealer’s other counterparties to enforce their remedies, thereby hastening the dealer’s collapse. This occurred, for example, in the case of [Lehman Brothers]. The second flaw is that there is ‘little actual evidence to support’ the claim that the collapse of a dealer might systemically disrupt the derivatives market. . . . [Lastly], the safe harbor itself appears to incentivize market concentration by enabling dealers and other parties to virtually ignore counterparty risk. . . . For this reason, creditors ‘are not overly concerned with their debtor’s financial stability, because they protect themselves with the debtor’s collateral, rather than with their understanding of the firm itself.’ “). 382 Between 1994 and 2006, the Bankruptcy Code had defined “securities contract” as follows: “securities contract” means contract for the purchase, sale, or loan of a security, including an option for the purchase or sale of a security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any option entered into on a national securities exchange relating to foreign currencies, or the guarantee of any settlement of cash or securities by or to a securities clearing agency; . . . . IV. Proposed Recommendations: Commencing the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 108 of 402 Bankruptcy Institute Other Commissioners observed that markets are increasingly global and interconnected, and they found value in maintaining the same level of protection for all true repurchase agreements. Some of these Commissioners, however, also agreed that the safe harbors should not protect disguised mortgage warehouse arrangements. The Commissioners explored removing transactions that facilitate short-term financing through a pledge of the assets, rather than a true sale. In the course of these discussions, the Commissioners discussed specifically excluding committed mortgage loan repurchase agreement facilities that function as mortgage warehouse facilities from the definitions of repurchase agreements and securities contracts and the safe harbors under the Bankruptcy Code. The Commission voted in favor of this exclusion, subject to its preference for a more extensive reduction in the safe harbors for repurchase agreements, as described in the preceding paragraph. 3. Assumption of Financial Contracts Recommended Principles: Under current law, several aspects of the safe harbors make it difficult for a trustee to exercise the traditional power under section 365 of the Bankruptcy Code to assume a derivative or other financial contract. For example, counterparties’ ability to enforce ipso facto clauses and terminate contracts protected by the safe harbors often make assumption of a derivative or other financial contract2016 impossible. r 21, e to Moreover, the safe harbors arguably allow counterparties mberemove valuable ov on N assets from the estate, such as when the debtor his ed the money on the contract c iv in 3 ar 3536 in question, especially if damages paid-upon termination do not compensate the . 14 , No own estate fully for loss of the. contract. Nevertheless, these challenges for the trustee v Br seth need to be ited in Blix against the volatile and systemic nature of the financial balanced c markets and the need to mitigate contagion in the larger economy. On balance and considering the proposed revisions to the safe harbors regarding the treatment of ordinary supply contracts, repurchase agreements, and walkaway clauses under these principles, the Commission does not believe further amendments to the safe harbors with respect to a trustee’s ability to assume derivative and other financial contracts are necessary or advisable. In addition, the Commission is aware of ongoing efforts to provide financially distressed systemically important financial institutions (or their subsidiaries that are parties to such contracts) with some ability to transfer derivative and other financial contracts in certain circumstances in the event that such institutions become debtors under the Bankruptcy Code. The Commission has decided to take no action with respect to such institutions. 11 U.S.C. § 741(7) (effective  Oct. 22, 1994 to Dec. 11, 2006). Between 2000 and 2004, the Bankruptcy Code had defined “repurchase agreement” as follows: “repurchase agreement” (which definition also applies to a reverse repurchase agreement) means an agreement, including related terms, which provides for the transfer of certificates of deposit, eligible bankers’ acceptances, or securities that are direct obligations of, or that are fully guaranteed as to principal and interest by, the United States or any agency of the United States against the transfer of funds by the transferee of such certificates of deposit, eligible bankers’ acceptances, or securities with a simultaneous agreement by such transferee to transfer to the transferor thereof certificates of deposit, eligible bankers’ acceptances, or securities as described above, at a date certain not later than one year after such transfers or on demand, against the transfer of funds; . . . . 11 U.S.C. § 101 (effective Dec. 21, 2000 to Oct. 24, 2004).  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 109 of 402 ABI Commission to Study the Reform of Chapter  Assumption of Financial Contracts: Background One consequence of the safe harbors is that counterparties can liquidate and close out qualified financial contracts with the debtor in possession, even if the debtor in possession’s383 positions under those contracts are in the money or the debtor in possession may be able to continue to perform or assign the contracts.384 As explained above, counterparties to qualified financial contracts generally are not subject to the automatic stay under section 362 and the prohibition on ipso facto clauses under section 365(e). These exceptions almost always preclude a debtor in possession’s ability to assume or assign qualified financial contracts because the contracts are terminated, liquidated, or accelerated on the debtor in possession’s petition date or shortly thereafter.385 Some commentators have argued against this result and in favor of a short stay that would allow the debtor in possession some ability to assume or assign some or all of its qualified financial contracts.386 This approach would be similar to that provided for systemically important financial institutions under the Orderly Liquidation Authority (“OLA”), Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.387 Under OLA, counterparties are enjoined for one business day from terminating, liquidating, or accelerating their positions under qualified financial contracts.388 Likewise, under different pieces of legislation proposed in Congress to address systemically important financial institutions under federal bankruptcy law, counterparties would be subject to a 48-hour stay before they could exercise any of their rights.389 Under OLA, the receiver is 16 given a brief opportunity to assign the bank’s qualified financial contracts (likely to a bridge or similar 1, 20 ber 2 vem institution) to facilitate its resolution, provided that certain conditions are satisfied. In the case of the n No ed o proposed Financial Institutions Bankruptcy Act,63 ardebtor (a systemically important bank holding the chiv -353 the stock of its subsidiaries to a special trust under 14 company) is given a brief opportunity,tootransfer N . rownestate is the beneficial owner of such trust.390 .B certain conditions, when thehdebtor’s et v ixs in Bl cited Assumption of Financial Contracts: Recommendations and Findings The Commission considered the potential utility of incorporating a short stay imposed on counterparties before they would be able to exercise their rights under qualified financial contracts against a debtor in possession upon the filing of its chapter 11 case. The Commissioners noted that this kind of short-term stay would primarily benefit the debtor in possession by allowing it to potentially (i) assume certain contracts when the debtor in possession is in the money or could continue to perform or (ii) assign such contracts to another entity. Although in theory both options 383 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. 384 See, e.g., Stephen J. Lubben, The Bankruptcy Code Without Safe Harbors, 84 Am. Bankr. L.J. 123, 129 (2010). 385 For a critique of the Bankruptcy Code’s treatment of qualified financial contracts in this respect, see Stephen Lubben, Derivatives and Bankruptcy: The Flawed Case for Special Treatment, 12 Univ. Penn. J. Bus. L. 61, 65–75 (2019). 386 Written Statement of Professor David Skeel: NYCBC Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 2–3 (May 15, 2013) (suggesting a three-day stay), available at Commission website, supra note 55; Written Statement of Edward Murray: NYCBC Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 4 (May 15, 2013) (stating that a short stay may be useful and that both the FDIC regime for U.S. banks and the Dodd-Frank Orderly Liquidation Regime both allow a short stay), available at Commission website, supra note 55. 387 12 U.S.C. § 5390(c)(10)(B). 388 Id. 389 See Taxpayer Protection and Responsible Resolution Act of 2014, S.1861, 113th Cong. § 1407 (2014) (adopting a proposal commonly referred to as “chapter 14”); Financial Institution Bankruptcy Act of 2014, H. 5421, 113th Cong. § 1187 (2014) (adopting a proposal commonly referred to as “subchapter V”). 390 OLA is discussed further in Section IX.D, SIFIs and Single Point of Entry Schemes. IV. Proposed Recommendations: Commencing the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 110 of 402 Bankruptcy Institute are appealing and hold potential value for the estate, the Commissioners questioned the ability of a debtor in possession to review its qualified financial contracts in such a meaningful and expeditious manner early in the chapter  11 case. They also raised concerns about structuring and funding a transaction early in the case in which the debtor in possession could effectively assign and transfer its qualified financial contracts. Many of the Commissioners also believed that, given the market stability and the systemic issues relating to these contracts, the debtor in possession would need to provide some type of adequate assurance to counterparties during the short-term stay, or otherwise compensate counterparties for any loss in value that they suffered while they were enjoined from exercising their rights under the contracts. Given these challenges, the Commissioners reexamined the concerns commonly expressed by parties in the safe harbor context in connection with the termination, liquidation, or acceleration of qualified financial contracts. These concerns often involve an estate losing the value of the debtor in possession’s position under a contract that is in the money or involve perceived abuses or unwarranted expansion of the safe harbor protections to transactions not directly related to the securities transfer system. The Commission agreed that its recommended principles addressing ordinary supply contracts, repurchase agreements, and walkaway clauses adequately addressed its primary concerns about the safe harbors. On balance, imposing a stay of the safe harbor protections would not enhance the debtor’s rehabilitation efforts. The Commission also acknowledged that the balancing of these issues may be different for systemically important financial institutions, but it 16 1, 20 noted pending legislative proposals on this topic. ber 2 on ived arch 5363 14-3 No. wn, . Bro eth v Blixs m Nove 4. Section 562 and “Commercially Reasonable Determinants of Value” in cited Recommended Principles: Section 562(b) should define “commercially reasonable determinants of value” as determinants of value specified in the contract that are not manifestly unreasonable or, in the absence of such determinants of value, commercially reasonable market prices. Section 562 and “Commercially Reasonable Determinants of Value”: Background Section 562 of the Bankruptcy Code addresses the “timing of damage measurement” when a qualified financial contract is rejected by a trustee391 or liquidated, terminated, or accelerated by a nondebtor counterparty.392 As a general rule, section 562(a) provides that damages should be measured as of the earlier of the date when the trustee rejects the qualified financial contract or the date when the nondebtor counterparty liquidates, terminates, or accelerates the qualified financial contract. If no 391 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. 392 11 U.S.C. § 562.  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 111 of 402 ABI Commission to Study the Reform of Chapter  commercially reasonable determinants of value exist on that date, however, section 562(b) provides that damages should be measured as soon as commercially reasonable determinants of value are available.393 Accordingly, the meaning of the term “commercially reasonable determinants of value” may play a central role in measuring damages under qualified financial contracts. Two issues commonly arise under section 562(b) and the application of the commercially reasonable determinants of value standard. First, there may be many commercially reasonable determinants of value, and what is “commercially reasonable” may depend on the surrounding circumstances. The court in American Home Mortgage Holdings, Inc. addressed this precise issue: the debtor suggested that the assets could be valued using a discounted cash flow analysis on one date (showing assets were worth more than the repurchase price) and the counterparty argued that the assets could not be valued until a later date when an actual price was available for the assets (showing assets were worth less than the repurchase price).394 The district and appellate courts in American Home agreed with the debtor’s analysis. The Commissioners questioned this result and noted that “commercially reasonable” is used in Article 9 of the Uniform Commercial Code in the context of sales procedures that are customary for the relevant market. Second, section 562 does not address the methodology to be used in calculating damages. Specifically, it is uncertain whether parties must adhere to a valuation methodology established by their contract or if they may use an alternative methodology provided that it is commercially reasonable under 6 the circumstances. The importance of this decision becomes more acute 1, commercially reasonable if 201 ber 2 v m determinants of value for purposes of the methodology requiredeby the contract do not exist on a n No ed o particular date, but the assets could be valued as363that date under another commercially reasonable of archiv -35 o. 14 methodology. n, N d h v. xset n Bli i Brow cite Section 562 and “Commercially Reasonable Determinants of Value”: Recommendations and Findings The Commission focused on two goals relating to section 562 of the Bankruptcy Code: providing certainty and preserving the expectations of the parties to prepetition contracts to the extent that they would not directly conflict with bankruptcy law or policy. The Commissioners reflected on the issues presented by the American Home Mortgage case and whether courts would potentially benefit from a determination about which type of valuation methodology should be used to calculate damages. Given the relevant policies of promoting market stability and respecting prepetition bargains whenever possible, the Commission determined that the contract terms should govern damages calculations in the first instance, unless those terms are manifestly unreasonable. The Commission used the “manifestly unreasonable” standard because precedent for that term in this context exists under Section 9-603 of the Uniform Commercial Code. 393 The legislative history of section 562 provides: The party determining damages is given limited discretion to determine the dates as of which damages are to be measured. Its actions are circumscribed unless there are no “commercially reasonable” determinants of value for it to measure damages on the date or dates of either rejection or liquidation, termination or acceleration. The references to “commercially reasonable” are intended to reflect existing state law standards relating to a creditor’s actions in determining damages. H.R. Rep. 109-31(I), H.R. Rep. No. 31(I) (2005), reprinted in 2005 U.S.C.C.A.N. 88. 394 In re Am. Home Mortg. Holdings, Inc., 411 B.R. 181 (Bankr. D. Del. 2009), aff ’d, 637 F.3d 246 (3d Cir. 2011). IV. Proposed Recommendations: Commencing the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 112 of 402 Bankruptcy Institute In addition, the Commission found value in specifying an appropriate methodology in the event that the contract is silent about damages calculation, or the contract provides a methodology that is determined to be manifestly unreasonable. The Commissioners discussed different alternatives, but ultimately agreed that the assets should be valued on the earliest date (after the triggering event) on which market prices are available. The Commissioners believed that specifying the role of the parties’ contract, as well as the use of market prices when a contract fails, for purposes of “commercially reasonable determinants of value” will facilitate more efficient damages calculations under section 562. 5. Walkaway Clauses Recommended Principles: The Bankruptcy Code should be amended to (i) include a definition of “walkaway clauses” substantially similar to the corresponding definitions in the Federal Deposit Insurance Act and Orderly Liquidation Authority and (ii) render unenforceable walkaway clauses in securities contracts, forward contracts, commodity contracts, repurchase agreements, swap agreements, and master netting agreements (i.e., qualified financial contracts). 16 1, 20 ber 2 vem n No ed o Walkaway Clauses: Background rchiv 63 a -353 . 14 , o In general, the terms “one-way payment,” N rown “limited two-way payment,” and “walkaway” refer to B h v. xse provisions in qualified financial tcontracts that, upon termination, liquidation or acceleration of a n Bli i cited particular transaction by the nondefaulting party, based on a default by the counterparty, eliminate the benefit of the contract to the defaulting counterparty even if the contract is in the money for that counterparty. The Bankruptcy Code does not specifically address walkaway clauses, other than in the context of repurchase agreements under section 559.395 Yet, these provisions can significantly impact the estate’s rights under qualified financial contracts if the debtor is deemed to be the defaulting party at the time of the rejection, termination, liquidation, or acceleration of the contract. For example, pursuant to a walkaway clause, a defaulting party is generally not entitled to any payments that are otherwise owed to it under the qualified financial contract (for example, if the debtor’s position is in the money at the time of the triggering event). Alternatively, the defaulting party may only be permitted to use its right to any payments to offset amounts it owes to the nondefaulting party. Notably, other laws specifically prohibit the enforcement of walkaway clauses. The Federal Deposit Insurance Act includes provisions that make walkaway clauses in qualified financial contracts of depository institutions that are in default unenforceable.396 The Orderly Liquidation Authority, which is a resolution regime that could apply to systemically important financial institutions, also renders 395 Section 559 of the Bankruptcy Code provides that, when a repo participant or financial participant liquidates one or more repurchase agreements with the debtor under which the repo participant or the financial participant agreed to deliver assets to the debtor, the repo participant or financial participant must pay to the debtor any excess value over the repurchase price that such liquidation yields, less any expenses in connection with the liquidation sale. See 11 U.S.C. § 559. Section 559 applies regardless of whether or not a repurchase agreement provides the debtor with payment rights. 396 12 U.S.C. § 1821(e)(8)(G)(i).  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 113 of 402 ABI Commission to Study the Reform of Chapter  walkaway clauses unenforceable.397 In addition, the Insurer Receivership Model Act, which is a model insurer insolvency act promulgated by the National Conference of Insurer Commissioners, renders walkaway clauses unenforceable in qualified financial contracts against an insurer undergoing insolvency proceedings that is deemed to be the defaulting party.398 Walkaway Clauses: Recommendations and Findings The Bankruptcy Code’s silence on walkaway clauses, other than in the section 559 context, creates ambiguity around their enforcement. The Commissioners discussed the cost of this uncertainty, both in terms of ex ante bargaining and ex post litigation. Courts are required to interpret walkaway clauses in qualified financial contracts in chapter 11 cases with little guidance and, presumably, in reliance on state law.399 This approach could produce results that are not only inconsistent with other chapter 11 cases, but also conflict with other federal and state laws. Accordingly, the Commission voted to preclude the enforcement of walkaway clauses in qualified financial contracts in chapter 11 cases. 6. Exclusion of “Ordinary Supply Contracts” from Safe Harbors 16 1, 20 ber 2 vem n No ed o iv The Bankruptcy Code should be amendedrch prevent nondealer counterparties to 63 a to -353 4 physical supply contractswn, No.benefiting from the safe harbor protections. from 1 ro B h v. xset n Bli i cited Recommended Principles: Exclusion of “Ordinary Supply Contracts” from Safe Harbors: Background As noted above, the safe harbors provide significant protections for counterparties to qualified financial contracts that otherwise are not available to creditors and contract parties under the Bankruptcy Code. These protections provide exceptions to several generally applicable bankruptcy rules and are focused on protecting the securities transfer system and the commodity hedging system and promoting market stability. Accordingly, the contracts included within the scope of “qualified financial contracts” are important from the perspectives of both the estate and counterparties. Generally speaking, qualified financial contracts include commodity contracts, forward contracts, securities contracts, repurchase agreements, and swap agreements, as well as related master netting agreements, as those terms are defined in the Bankruptcy Code. These definitions are worded fairly broadly. For example: 397 Id. § 5390(c)(8)(F)(i). OLA and systemically important financial institutions are discussed in greater detail in Section IX.D, SIFIs and Single Point of Entry Schemes. 398 Model Insurer Receivership Act § 711. 399 See Drexel Burnham Lambert Prod. Corp. v. Midland Bank PLC, 1992 U.S. Dist. LEXIS 21223 (S.D.N.Y. Nov. 10, 1992) (applying New York law to render walkaway clause unenforceable). IV. Proposed Recommendations: Commencing the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 114 of 402 Bankruptcy Institute The term “forward contract” is defined as including “a contract (other than a commodity contract, as defined in section 761) for the purchase, sale, or transfer of a commodity, as defined in section 761(8) of this title, or any similar good, article, service, right, or interest which is presently or in the future becomes the subject of dealing in the forward contract trade, or product or byproduct thereof, with a maturity date more than two days after the date the contract is entered into, including, but not limited to, a repurchase or reverse repurchase transaction (whether or not such repurchase or reverse repurchase transaction is a ‘repurchase agreement’, as defined in this section) consignment, lease, swap, hedge transaction, deposit, loan, option, allocated transaction, unallocated transaction, or any other similar agreement.”400 The term “commodities contract” means, among other things, “with respect to a futures commission merchant, contract for the purchase or sale of a commodity for future delivery on, or subject to the rules of, a contract market or board of trade.”401 The term “swap contract” includes, “a commodity index or a commodity swap, option, future, or forward agreement.”402 Consequently, parties have argued and some courts have held that ordinary supply agreements constitute protected qualified financial contracts under the Bankruptcy Code safe harbors.403 As the Fifth Circuit explained, courts must “apply the statutory provisions as Congress wrote them,” and it 6 found no grounds for excluding the electricity requirements contract from 21, 2Bankruptcy Code’s the 01 ber ovem definition of forward contracts.404 on N ived arch 363 5 Although many long-term supply contracts o. 14-3 have some hedging component to them, some courts n, N row and commentators have questionedBwhether the objectives of the safe harbors are best served th v. lixse by including ordinaryted in B agreements within those protections. As explained by the court in ci supply National Gas Distributors: Congress determined that there are legitimate reasons for creating, in the financial markets, these special exceptions to the overall protections and policies of the Code. The court understands that if contracts traded on a financial market are unraveled, the market itself could become unstable and a domino effect could occur. There is nothing to suggest that the contract between Smithfield and the debtor was traded on a financial market, so in this case only the debtor’s estate and Smithfield would be affected by a recovery. There is no reason to disturb the established ability of the trustee to avoid the alleged fraudulent transfers at issue in this case. The consequences of including agreements such as the one before the court within the definition of swap agreement would be far-reaching. . . . These exceptions to the trustee’s avoidance powers were intended to avoid the greater danger of market disruption and instability in the financial markets due to the domino effect likely as 400 401 402 403 11 U.S.C. § 101(25). Id. § 761(4). Id. § 101(53B). See, e.g., Lightfoot v. MXEnergy Elec., Inc. (In re MBS Mgmt. Servs., Inc.), 690 F.3d 352 (5th Cir. 2012); (5th Cir. Aug. 2, 2012) (characterizing electric requirements contracts as forward contracts under the Bankruptcy Code); In re Nat’l Gas Distribs., LLC, 556 F.3d 247 (4th Cir. 2009) (finding that natural gas supply contract could constitute a commodities forward contract and, as such, a swap agreement under the Bankruptcy Code). 404 Lightfoot v. MXEnergy Elec., Inc. (In re MBS Mgmt. Servs., Inc.), 690 F.3d 352 (5th Cir. 2012).  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 115 of 402 ABI Commission to Study the Reform of Chapter  a result of some types of transfer avoidance. Congress certainly did not intend by the amendment to create a new, equally disruptive ripple effect within the administration of bankruptcy estates. The court must take into consideration the effect its decision will have on the overall scheme of the Bankruptcy Code. If this agreement is a swap agreement, then many of the most important aspects of the Code, including priorities of distributions to creditors and the automatic stay, will be eviscerated in even the smallest case of a farmer who contracts to sell his hogs at the end of the month for a set price. No public purpose would be served, and the result would be wholly at odds with the established aims and order of bankruptcy proceedings. . . .405 Exclusion of “Ordinary Supply Contracts” from Safe Harbors: Recommendations and Findings The Commissioners discussed the potential inclusion of ordinary supply contracts in the Bankruptcy Code safe harbors. The safe harbors were designed to promote liquidity and stability in financial markets. Market liquidity and stability are not furthered in a meaningful way when ordinary supply agreements are safe harbored. Although distinguishing “ordinary” supply agreements from bona fide financial contracts is difficult, the Commission found value in considering (i) whether the contract involved dealers, market makers, or other parties; and (ii) whether the contract called for the physical supply of goods used, traded, or produced by the debtor in the ordinary course of 16 1, 20 business. ber 2 m ve n No ed o rchiv The Commissioners analyzed the courts’ interpretation of the terms “forward contracts” and “swap 63 a -353 . 14 agreements” under the BankruptcyoCode. They acknowledged how an ordinary supply contract could , No r wn B be construed or drafted lito eth v. the technical requirements of these definitions. The larger issue, xs satisfy nB i ited however, for thecCommission was whether these terms should include ordinary supply contracts. The legislative history of the safe harbors clearly establishes a desire to protect the securities transfer system and promote market stability. Although the Commissioners could hypothesize scenarios in which subjecting the nondebtor party to an ordinary supply contract to the Bankruptcy Code’s automatic stay and other provisions could possibly affect others in the market, the Commissioners found those scenarios highly unlikely and, even if possible, very limited in scope. Most ordinary supply contracts are bilateral agreements that impact only the rights of the parties bound by the contract. The Commissioners acknowledged the hardship that may be imposed on the nondebtor party by the chapter 11 filing, but they did not find such hardship significantly different from that experienced by most of the debtor’s stakeholders. In discussing the scope of qualified financial contracts, several Commissioners noted the need to critically analyze any exceptions to, or priorities created by, the Bankruptcy Code.406 These 405 In re Nat’l Gas Distribs., LLC, 369 B.R. 884, 899–900 (Bankr. E.D.N.C. 2007), rev’d on other grounds, 556 F.3d 247 (4th Cir. 2009) (citations omitted). 406 See, e.g., Howard Delivery Service, Inc. v. Zurich Am. Ins. Co., 547 U.S. 651, 667 (2006) (noting that the Court was “guided in reaching [its] decision by the equal distribution objective underlying the Bankruptcy Code, and the corollary principle that provisions allowing preferences must be tightly construed.”); Trustees of Amalgamated Ins. Fund v. McFarlin’s, Inc., 789 F.2d 98, 100 (2d Cir. 1986) (“Because the presumption in bankruptcy cases is that the debtor’s limited resources will be equally distributed among his creditors, statutory priorities are narrowly construed.”). See also Written Statement of Daniel Kamensky on behalf of Managed Funds Association: LSTA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (Oct. 17, 2012) (“These changes reflect a pervasive trend away from the fundamental concept of equality for similarly situated creditors IV. Proposed Recommendations: Commencing the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 116 of 402 Bankruptcy Institute Commissioners reiterated the importance of the policies underlying the Bankruptcy Code, including a breathing period for the debtor, a level playing field among the debtor and its stakeholders, and fair treatment of all similarly situated creditors, in facilitating a successful reorganization.407 For example, if all or a substantial majority of a debtor’s contracts could be terminated by the nondebtor parties, or most creditors were entitled to priority payments or protected from avoidance actions, the utility of chapter 11 would be significantly reduced, if not eliminated. The Commission voted to exclude ordinary supply agreements from the safe harbors. In reaching this conclusion, the Commissioners emphasized that the exclusion from the safe harbors should be limited to nondealer counterparties’ physical supply contracts, including contracts for the supply of natural gas and electricity. in cited 16 1, 20 ber 2 vem n No ed o rchiv 63 a -353 . 14 , No rown .B eth v Blixs in bankruptcy and, in the aggregate, make it harder for a company to reorganize. As such, MFA urges the Commission to take a fresh look at the existing categories of preferred creditors, and to strongly oppose any proposals that would create additional priority categories or other preferential treatment for particular creditor groups.”). 407 Numerous courts have held that “it is the clear policy of the Bankruptcy Code to provide the debtor with breathing space following the filing of a bankruptcy petition, continuing until the confirmation of a plan, in which to assume or reject an executory contract.” In re Adelphia Commc’ns Corp., 291 B.R. 283, 292 (Bankr. S.D.N.Y. 2003) (citations omitted). See also Theatre Holding Corp. v. Mauro, 681 F.2d 102, 105–06 (2d Cir. 1982); In re Enron Corp., 279 B.R. 695, 702 n.8 (Bankr. S.D.N.Y. 2002); In re Teligent, Inc., 268 B.R. 723, 738 (Bankr. S.D.N.Y. 2001); In re Beker Indus. Corp., 64 B.R. 890, 897 (Bankr. S.D.N.Y. 1986). But see In re Enron Corp., 279 B.R. 695, 702 (Bankr. S.D.N.Y. 2002) (noting that “the breathing space afforded to the debtor for the assumption or rejection of executory contract is not without limits.”).  IV. Proposed Recommendations: Commencing the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 117 of 402 16 1, 20 ber 2 vem n No ed o rchiv 63 a -353 . 14 , No rown .B eth v Blixs V. PROPOSED RECOMMENDATIONS: ADMINISTERING THE CASE in cited AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 118 of 402 Bankruptcy Institute A. Executory Contracts and Leases Section 365 of the Bankruptcy Code generally allows a debtor in possession to assume, assign, or reject executory contracts and unexpired leases in the chapter 11 case.408 The debtor in possession typically makes this determination based on a variety of factors, including whether the contract or lease is above or below market, necessary to its ongoing business operations, and subject to assumption under the Bankruptcy Code. It also may consult with the unsecured creditors’ committee on these issues or attempt to renegotiate the contract or lease with the nondebtor party. A debtor in possession’s decision to assume, assign, or reject an executory contract or unexpired lease is subject to court approval, certain deadlines, and several other requirements detailed in section 365.409 1. Definition of Executory Contract Recommended Principles: The Bankruptcy Code should define the term “executory contract” for purposes of section  365 as “a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach16 excusing 1, 20 ber 2 not constitute the performance of the other,” provided that forbearancevshould em n No ed o in Bankruptcy: Part I, 57 performance. Vern Countryman, Executory Contracts rchiv 63 a Minn. L. Rev. 439, 460 (1973). Theocontours of this definition are well developed -353 14 N . under the case law and vreflect ,an appropriate balance between the rights of a rown B h . x et trustee to assumeBorsreject contracts unilaterally under the Bankruptcy Code and n li i cited the nondebtor’s obligations and rights in those circumstances. Definition of Executory Contract: Background Section 365(a) provides that a debtor in possession,410 “subject to the court’s approval, may assume or reject any executory contract or unexpired lease of the debtor.”411 The Bankruptcy Code does not define “executory contract,” and the legislative history of section 365 provides little guidance.412 Accordingly, the court on a case-by-case basis determines whether a particular contract is executory. Courts traditionally have used what is commonly referred to as the “Countryman” definition of executory contracts.413 This test was developed by Professor Vern Countryman and defines an 408 11 U.S.C. § 365. 409 See, e.g., id. § 365(b) (requirements for assumption); id. § 365(c) (contracts not subject to assumption or assignment); id. § 365(f) (requirements for assignments). 410 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. 411 11 U.S.C. § 365(a). 412 H.R. Rep. No. 95-595, at 347 (1977) (“Though there is no precise definition of what contracts are executory, it generally includes contracts on which performance remains due to some extent on both sides.”). 413 See In re Baird, 567 F.3d 1207, 1211 (10th Cir. 2009); In re Columbia Gas Sys., Inc., 50 F.3d 233, 239 (3d Cir. 1995); In re Streets & Beard Farm P’ship, 882 F.2d 233, 235 (7th Cir. 1989); Lubrizol Enters., Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043, 1045 (4th Cir. 1985); In re Select-A-Seat Corp., 625 F.2d 290, 292 (9th Cir. 1980).  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 119 of 402 ABI Commission to Study the Reform of Chapter  executory contract for bankruptcy purposes as “a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other.”414 Although widely used, courts have recognized limitations and potential inconsistencies in the application of the Countryman test.415 In addition, the test may not be a good fit for certain kinds of contracts.416 Given the noted flaws in the Countryman test, courts have developed alternative approaches to assess executoriness. For example, some courts use the “functional approach” to evaluate a debtor in possession’s request to assume or reject an executory contract. Under this approach, developed by Professor Jay Westbrook, there is no threshold standard of “executoriness” that the debtor in possession must meet to assume or reject the contract.417 Rather, the functional approach focuses on whether assumption or rejection would create a benefit for the bankruptcy estate and its creditors. The functional approach recognizes that courts often manipulate the threshold requirement of executoriness in order to produce the desired outcome.418 Several courts have adopted the functional approach or used it in connection with the Countryman test.419 Another alternative approach is commonly referred to as the “exclusionary approach.” This approach is a deviation from the Countryman test and was developed by Michael Andrew.420 The following are the primary differences between the Countryman test and the exclusionary approach: (i) the 6 concept of executoriness is irrelevant in the rejection context;421 ander 21,a 01 (ii) 2 contract is executory if b each party has unperformed obligations, and if the debtor’s Novem on nonperformance eliminates its right ived arch 363 -35 o. 14 n, N ow v. Br 414 Vern Countryman, Executoryseth lix Contracts in Bankruptcy: Part I, 57 Minn. L. Rev. 439, 460 (1973). 415 See, e.g., In re Gen.ted inCorp., 84 F.3d 1364, 1374 (11th Cir. 1996); In re RoomStore Inc., 473 B.R. 107, 111–12 (Bankr. E.D. Va. Dev. B ci 2012). 416 Some courts have struggled with the application of the Countryman definition in the context of the following kinds of agreements: options and rights of first refusal; restrictive covenants (covenants not to compete; restrictive covenants on land); oil and gas agreements (e.g., the oil and gas leases themselves and variations thereof, like farmout agreements;, and related agreements, like surface use agreements and joint operating agreements); licenses, distributor agreements, and trademark agreements; warranties; rights of first refusal; employment contracts; and severance agreements; arbitration clauses; forum selection clauses; distributor agreements; trademark agreements; and indemnity clauses; and settlement agreements. See, e.g., Water Ski Mania Estates Homeowners Ass’n v. Hayes (In re Hayes), 2008 Bankr. LEXIS 4668, at *31–32 (B.A.P. 9th Cir. Mar. 31, 2008) (“[A] lthough restrictive covenants contain the characteristics of both a contract and an interest in land, the primary nature of such covenants is preservation of a land interest, not future duties in contract. Although there will almost always be some incidental continuing obligations under a restrictive covenant, those duties were not the kind of obligations Congress intended to impact in enacting § 365.”) (citation omitted); Frontier Energy, LLC v. Aurora Energy, Ltd. (In re Aurora Oil & Gas Corp.), 439 B.R. 674, 680 (Bankr. W.D. Mich. 2010) (“The court’s conclusion that the [oil and gas leases] qualify as ‘leases’ within the meaning of Section 365 makes it unnecessary to consider whether the [oil and gas leases] meet either the functional test or Countryman definition for executory contracts. Given the confusion in the case law, it is also improvident to opine on the question.”) (citations omitted); In re Bergt, 241 B.R. 17, 29–31 (Bankr. D. Alaska 1999) (discussing the application of the Countryman test in recent case law to options); Bronner v. Chenoweth-Massie, P’ship (In re Nat’l Fin. Realty Trust), 226 B.R. 586, 589 (Bankr. W.D. Ky. 1998) (“The contingent nature of the obligations arising from an option agreement make them quite distinguishable from the typical contract. This distinction has puzzled many courts, resulting in two distinct lines of cases. The first line of cases, while recognizing the contingent nature of the obligations arising under option agreements, and while also expressly acknowledging that they are unilateral contracts until exercised, have nevertheless engaged in what could be described as analytical gymnasts to arrive at a finding that they are nonetheless executory contracts.”) (citations omitted); Cohen v. Drexel Burnham Lambert Grp., Inc. (In re Drexel Burnham Lambert Grp., Inc.), 138 B.R. 687, 699 (Bankr. S.D.N.Y. 1992) (“Our readings persuade us that in each case, use of the Countryman test was neither necessary nor determinative. It was, rather, merely window dressing for results determined in the first instance by resort to another, sometimes unspecified criterion.”) (analyzing case law regarding application of Countryman test to employment agreements). See also infra note 424. 417 Jay L. Westbrook, A Functional Analysis of Executory Contracts, 74 Minn. L. Rev. 227, 282–85 (1989). 418 Id. at 287. 419 See, e.g., Route 21 Assoc. of Belleville, Inc., v. MHC, Inc., 486 B.R. 75 (S.D.N.Y. 2012); In re Majestic Capital, Ltd., 463 B.R. 289, 300 (Bankr. S.D.N.Y. 2012). 420 Michael T. Andrew, Executory Contracts in Bankruptcy: Understanding “Rejection,” 59 U. Colo. L. Rev. 845 (1988); Michael T. Andrew, Executory Contracts Revisited: A Reply to Professor Westbrook, 62 U. Colo. L. Rev. 1 (1991). 421 Andrew, Executory Contracts in Bankruptcy, supra note 420, at 894. V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 120 of 402 Bankruptcy Institute to the other party’s performance.422 Although courts have not adopted this approach, they have considered its factors in applying other tests.423 Definition of Executory Contract: Recommendations and Findings The Commission conducted an in-depth review of the literature and case law on executoriness under the Bankruptcy Code. Some of the Commissioners noted their experience with litigation concerning the executoriness issue and the attendant uncertainty and expense. The focus of the executoriness inquiry is whether each party has significant unperformed obligations under the contract.424 The Commissioners discussed examples of contracts when this issue may be of particular concern, such as options, covenants not to compete, and oil and gas leases.425 Although executoriness is not necessarily a bright-line determination, the Commissioners generally agreed that courts resolve this issue fairly or parties are able to negotiate a resolution. The Commission also considered the possibility of eliminating the concept of executoriness from the Bankruptcy Code. Both the advisory committee and the 1997 NBRC endorsed this position.426 The Commissioners debated at length the potential utility to this approach. They discussed the meaningful benefits to refocusing contract disputes on the merits of the proposed assumption or rejection rather than extensive litigation on executoriness. The Commissioners supporting this approach emphasized the value to such a clean solution: with the distraction of executoriness off 16 1, 0 the table, parties could devote more attention on their rights, obligations, rand 2 be 2 remedies under the em n No contract. Many Commissioners found the simplicity of this approachvattractive. ed o rchiv 63 a -353 4 Further deliberations about the elimination No. 1 , proposal revealed, however, the potential of unintended rown consequences of such a dramaticth v. B in a fundamental bankruptcy principle. The Commissioners ixse shift in Bl edorigins of the executoriness requirement of section  365,427 and they also noted the common law cit 422 Id. at 893. 423 See, e.g., In re Family Snacks, Inc., 257 B.R. 884, 905 (B.A.P. 8th Cir. 2001). 424 The Seventh Circuit Court of Appeals explained: The Bankruptcy Code’s legislative history states that the term “executory contract” “generally includes contracts on which performance is due to some extent on both sides.’ A common definition, which this court has cited with approval, states that a contract is executory for bankruptcy purposes where “the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure to complete performance would be a material breach excusing the performance of the other.” In re Crippin, 877 F.2d 594, 596 (7th Cir. 1989). See also Counties Contracting & Constr. Co. v. Constitution Life Ins. Co., 855 F.2d 1054, 1060 (3d Cir. 1988) (“The [Bankruptcy] Code does not define the term executory contract, however, courts have generally employed what has become known as the ‘Countryman’ definition of an executory contract, i.e., a contract under which the obligations of both the bankrupt and the other party remain so far unperformed that failure of either to complete performance would constitute a material breach excusing performance of the other.”) (citation omitted). 425 See, e.g., COR Route 5 Co., LLC v. Penn Traffic Co. (In re Penn Traffic Co.), 524 F.3d 373, 380 (2d Cir. 2008) (“While some courts have held that options contracts under which the optionee fully paid its price for the option to buy property before the debtor filed for bankruptcy are not executory (because no performance is due from the optionor unless the option is exercised), . . . others treat such contracts as executory.”) (citing conflicting case law) (citations omitted); Powell v. Anadarko E&P Co., L.P. (In re Powell), 482 B.R. 873, 877–78 (Bankr. M.D. Pa. 2012) (“Some courts have assumed that an oil and gas lease is an executory contract. Other courts have considered an oil and gas lease a transfer of an interest in real property and therefore not an executory contract.”) (citing conflicting case law) (citations omitted); In re Teligent, Inc., 268 B.R. 723, 730–31 (Bankr. S.D.N.Y. 2001) (“As a rule, Delaware law treats the covenant not to compete and the reciprocal promise to pay as material. As a result, the failure to make payment will discharge the obligation not to compete. . . . Where the covenant is given in connection with the sale of a business, it is even more likely to be deemed material. A covenant not to compete is often included in a contract to sell a business to protect the purchaser and allow him to enjoy the built-up good will.”). 426 See NBRC Report, supra note 37, at 21 (“Title 11 should be amended to delete all references to ‘executory’ in section 365 and related provisions, and ‘executoriness’ should be eliminated as a prerequisite to the trustee’s election to assume or breach a contract.”). 427 See In re Austin Dev. Co., 19 F.3d 1077, 1081 (5th Cir. 1994) (“Section 365 derives from § 70(b) of the former Bankruptcy Act, a provision that broadly codified the common law doctrine that allowed the trustee either to assume and perform the debtor’s  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 121 of 402 ABI Commission to Study the Reform of Chapter  perceived value in maintaining some type of gating feature to vet those contracts that a debtor in possession could assume, assign, or reject in the chapter 11 case. Thus, the elimination of the executoriness concept could simply shift, rather than reduce, the amount of litigation or uncertainty in the first instance under section 365. Moreover, many Commissioners believed that the assumption or rejection decision was largely irrelevant to contracts that have already been fully performed by at least one of the parties. The Commissioners also discussed the functional approach to determining executoriness, but most perceived the test to be unfair toward counterparties and too heavily weighted in favor of the interests of the debtor and the estate. The Commissioners acknowledged the potential value of allowing a debtor in possession to assume or reject any contract that would provide a benefit to the estate. As with the elimination proposal, however, the Commissioners were concerned about diminishing the rights of the nondebtor counterparties under the contracts. Subjecting any contract to section 365 primarily, if not solely, for the benefit of the estate imposed a greater burden on nondebtor parties than necessary to achieve a fair result for the estate in a chapter 11 case. On balance, the Commission voted to adopt the Countryman test and to recommend its express incorporation into the Bankruptcy Code. The Commission found that, although imperfect, the Countryman test strikes an appropriate balance between the rights of debtors in possession and nondebtor counterparties to a contract. If the parties have material unperformed obligations, it is 16 fair and reasonable to allow a debtor to choose to assume, assign, or reject,such an agreement under 1 20 ber 2 section 365. The Commission also determined that many ofothe ovem N potentially challenging issues under d n chive that this case law is a valuable resource the Countryman test have been resolved by the363 ar and courts -35 . 14codified standard. that would guide the implementation ,of o n N the cited h v. xset n Bli i Brow 2. General Rights of Private Parties to Executory Contracts and Unexpired Leases Recommended Principles: A nondebtor party to an executory contract or unexpired lease with the debtor should be required to continue to perform under such contract or lease after the petition date, provided that the trustee needs such continued performance and pays for any products or services delivered after the petition date on a timely basis as required by the contract or lease. In paying for such products or services, however, the trustee should not be subject to any modifications or rate changes in the contract or lease triggered by the debtor’s bankruptcy filing, insolvency, or prepetition default. Except as provided in section 365(d)(3) of the Bankruptcy Code (and the principles for that section, see Section V.A.6, Real Property Leases) and in section 365(d)(5) of the Bankruptcy Code, the trustee does not otherwise have an leases or executory contracts or to ‘reject’ them if they were economically burdensome to the estate.”). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 122 of 402 Bankruptcy Institute obligation to perform, or to cure any defaults, under such contract or lease prior to the assumption of that contract or lease under section 365(a). The nondebtor party should be permitted to compel the trustee to perform other postpetition obligations under the contract or lease if the court determines, after notice and a hearing, that the harm to the nondebtor party resulting from the trustee’s nonperformance significantly outweighs the benefit to the estate derived from such nonperformance. The court should limit the trustee’s performance obligation to that which is necessary to mitigate the harm to the nondebtor party pending assumption or rejection. The nondebtor party should bear the burden of proof in any such hearing. The trustee should not be required to cure nonmonetary defaults that occur prior to the assumption of the executory contract or unexpired lease and that are impossible for the debtor to cure at the time of the proposed assumption under section 365(a) and (b). These principles governing the rights of parties to executory contracts and unexpired leases are intended to apply only to contracts and leases between private parties and should not affect the debtor’s contracts or leases with any state or federal governments. 16 1, 20 ber 2 vem n No ed o rc iv General Rights of Private Parties to ExecutoryhContracts and Unexpired 63 a -353 . 14 Leases: Background , No rown B h v. xset n Bli debtor in possession428 does not make its decision to assume, assign, In most chapter 11 cases,i the cited or reject executory contracts and unexpired leases on, or even shortly after, the petition date. As such, there is a gap period between the petition date and the treatment decision under section 365. The Bankruptcy Code requires the debtor in possession to perform timely obligations arising under nonresidential real property leases, certain personal property leases,429 and intellectual property licenses,430 but does not otherwise address performance during the gap period.431 In light of this silence, “most courts agree that before an executory contract is assumed or rejected under § 365(a), that contract continues to exist, enforceable by the debtor in possession, but not enforceable against the debtor in possession.”432 428 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. 429 11 U.S.C. § 365(d)(5). This provision for personal property leases applies only in chapter 11 cases. Id. If the case is initially filed under chapter 11 and later converted to chapter 7, section 365(d)(5) will no longer apply. 3 Collier on Bankruptcy ¶ 365.04[2][c]. 430 11 U.S.C. § 365(n). 431 Id. § 365(d)(3). The court “may extend, for cause, the time for performance of any such obligation that arises within 60 days after the date of the order for relief, but the time for performance shall not be extended beyond such 60-day period.” Id. 432 See, e.g., In re Nat’l Steel Corp., 316 B.R. 287, 305 (Bankr. N.D. Ill. 2004) (collecting cases). See also Howard C. Buschman III, Benefits and Burdens: Postpetition Performance of Unassumed Executory Contracts, 5 Bankr. Dev. J. 341, 343 (1988) (citing Douglas Bordewieck & Vern Countryman, The Rejection of Collective Bargaining Agreements by Chapter 11 Debtors, 57 Am. Bankr. L.J. 239, 332 (1983)); 2 Collier on Bankruptcy ¶ 365.03, 365-28, 365-29 (15th ed. 1988); 8 Collier on Bankruptcy ¶ 3.15(6) at 204 (14th ed. 1978).  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 123 of 402 ABI Commission to Study the Reform of Chapter  Courts generally justify this one-sided performance requirement by emphasizing the importance of the breathing spell created by the automatic stay for the debtor in possession,433 and the severe consequences that may result from a rushed or premature decision to assume, assign, or reject an executory contract or unexpired lease.434 They also acknowledge the burden such one-sided performance may impose on the nondebtor party, but on balance find in favor of the estate. The nondebtor party may seek to compel performance or a treatment decision by the debtor in possession under section 365, and it frequently requests an administrative claim under section 503(b)(3) for any postpetition obligations that the debtor in possession fails to perform.435 Once a debtor in possession decides to assume an executory contract or unexpired lease, section 365(b) requires the debtor in possession to cure or provide adequate assurance of a prompt cure of any defaults under the contract or lease. Section 365(b)(1) indicates that nonmonetary defaults that are impossible to cure under unexpired leases for nonresidential real property do not require cure, “except that if such default arises from a failure to operate in accordance with a nonresidential real property lease, then such default shall be cured by performance at and after the time of assumption in accordance with such lease, and pecuniary losses resulting from such default shall be compensated in accordance with the provisions of this paragraph.”436 Section 365(b)(2) further provides that a debtor in possession’s general cure obligations under section 365(b)(1) do not apply to “the satisfaction of any penalty rate or penalty provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the executory contract or unexpired lease.”437 Some courts 6 , 201 have interpreted section 365 to preclude the assumption of executorybcontracts and unexpired leases er 21 m (other than real property leases) if non-curable historicalon Nove nonmonetary defaults exist under the ed iv arch contract or lease.438 5363 -3 o. 14 n, N Brow th v. lixse Rightsdof B in Private Parties to Executory cite General Leases: Recommendations and Findings Contracts and Unexpired The chapter 11 filing can have significant negative implications for a nondebtor party’s business. Accordingly, the Commission carefully scrutinized the postpetition needs of a debtor in possession with respect to executory contracts and unexpired leases. The Commissioners discussed the importance of a reliable, steady supply of goods and services used in the debtor’s business to the debtor in possession’s reorganization efforts. They also acknowledged that nondebtor parties frequently threaten to stop providing goods or services unless the debtor in possession satisfies certain conditions. Although the Commissioners understood the nondebtor party’s desire for more 433 See, e.g., In re Cont’l Energy Assocs. Ltd. P’ship, 178 B.R. 405, 408 (Bankr. M.D. Pa. 1995) (“Not only does this saddle an ailing company with an additional burden which it is unlikely to overcome, it pressures the Debtor to surrender the ‘breathing space’ normally allowed to it to consider the assumption or rejection of the contract.”). 434 11 U.S.C. § 365(g)(2). Post-assumption rejection is treated as a breach at the time of rejection (i.e., postpetition). Id. Where a contract or lease is assumed in a chapter 11 case that is later converted to a chapter 7 and then the contract or lease is rejected in the chapter 7 case, the rejection would be treated as having occurred immediately before the date of conversion. 1 Collier Handbook for Trustees & Debtors in Possession ¶ 14.07 (2012). 435 11 U.S.C. § 503(b). The extent of the nondebtor party’s administrative claim, however, may be limited by the court under the “benefit to the estate” standard of section 503(b). See Mason v. Official Comm. of Unsecured Creditors (In re FBI Distrib. Corp.), 330 F.3d 36, 42–43 (1st Cir. 2003) (“[T]he nondebtor party will be entitled to administrative priority only to the extent that the consideration supporting the claim was supplied to the debtor in possession during the reorganization and was beneficial to the estate.”); In re Nat’l Steel Corp., 316 B.R. 287, 301 (Bankr. N.D. Ill. 2004) (“Claims under § 503(b)(1)(A) are to be measured by the benefit received by the estate rather than the cost incurred by a claimant.”). 436 11 U.S.C. § 365(b)(1). 437 Id. § 365(b)(2). 438 See, e.g., In re Carterhouse, Inc., 94 B.R. 271, 273 (Bankr. D. Conn. 1988) (holding that section 365(b)(1) “extends to nonmonetary as well as monetary breaches”). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 124 of 402 Bankruptcy Institute certainty and for some kind of adequate assurance, they found the general principles underlying the postpetition performance requirements to be sound. Reflecting on the circumstances of nondebtor parties in these cases, however, the Commissioners considered various ways to mitigate the burden imposed by the general postpetition performance requirement. They did not believe that the debtor in possession should be required to provide adequate protection under section 361 of the Bankruptcy Code or to cure any historical defaults prior to assumption or rejection of the contract or lease. They also rejected full performance of the contract or lease by the debtor in possession, agreeing with courts that hold such a requirement undercuts the value of the automatic stay in the debtor in possession’s reorganization efforts. The Commissioners debated the feasibility of requiring the debtor in possession to pay for goods and services actually provided to the debtor in possession postpetition in accordance with the terms of the contract or lease. Some Commissioners commented that the debtor in possession may not have the liquidity to meet this standard on an immediate postpetition basis, while others indicated that the debtor in possession’s needs in this respect could be factored into the postpetition financing budget.439 The Commissioners stressed the need for any such payment obligation to be limited to those goods and services needed by, and provided to, the debtor in possession postpetition and that the nondebtor party should not be able to enforce more onerous payment terms from, or demand any other type of performance of, the debtor in possession pending assumption or rejection of the 6 contract or lease.440 The terms of the prepetition contract or lease should 21, 201 the timing and govern ber ve unless the parties mutually amount of the debtor in possession’s postpetition payment obligations,m n No ed o iv arch agree to more beneficial terms for the estate. 363 -35 o. 14 n, N B w The Commissioners also analyzed the ro th v. circumstances under which nondebtor parties should be able lixse to seek to compel fullited in B c or greater postpetition performance by the debtor in possession under the contract or lease. The Commissioners generally believed that nondebtor parties should have this option, but that the standard of proof should be stringent and that the nondebtor party should bear the burden of proof, particularly in light of the Commission’s recommendation to require some postpetition payment by the debtor in possession. The Commission ultimately determined that this standard was an appropriate balance and recommended the joint proposal of requiring payment solely for goods or services provided to the debtor in possession postpetition and placing a high evidentiary burden on the nondebtor party that seeks to compel further or other postpetition performance. The Commissioners also discussed the potential impact of these provisions on government contracts. In light of the different and varied interests that may be implicated by government contracts, the Commission agreed that these contracts be excluded from the recommended principles governing postpetition performance of executory contracts and unexpired leases and that such principles be limited to the rights of private parties to executory contracts and unexpired leases with a debtor. 439 Some of the Commissioners proposed incorporating an “adequate assurance” concept similar to Section 2-609 of the Uniform Commercial Code, but others believed that this would provide too much leverage for counterparties in terms of holdup value. 440 Written Statement of Elizabeth Holland on behalf of the International Council of Shopping Centers: NYIC Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 3–4 (June 4, 2013) (stating that retailers are failing because of the reluctance of trade creditors to extend credit on reasonable terms and the difficulty of obtaining DIP and exit financing to support reorganization), available at Commission website, supra note 55; id. at 5 (citing the January 2013 Senior Loan Officer Opinion Survey on Bank Practices from the Federal Reserve which indicates that DIP lending is tight and trade vendors are unwilling to extend credit except on onerous terms).  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 125 of 402 ABI Commission to Study the Reform of Chapter  Finally, the Commissioners addressed the continued confusion in the case law concerning a debtor in possession’s obligation to cure historical nonmonetary defaults in order to assume the executory contract or unexpired lease. The Commissioners acknowledged that the BAPCPA Amendments to the Bankruptcy Code clarified this issue for real property leases, but that ambiguity remained for other kinds of leases and executory contracts. The Commissioners debated whether certain kinds of historical nonmonetary defaults were so central to a contract’s or lease’s purpose that their nonperformance should bar assumption. On balance, the Commission determined that, with respect to all executory contracts and unexpired leases, a debtor in possession should not be required to cure nonmonetary defaults occurring prior to the assumption decision that are impossible to cure at the time of assumption under section 365(b) of the Bankruptcy Code. 3. Rejection of Executory Contracts and Unexpired Leases Recommended Principles: The rejection of an executory contract or unexpired lease should continue to constitute a breach of the contract or lease as of the time immediately preceding the commencement of the case under section 365(g) of the Bankruptcy Code. The 16 trustee’s rejection of an executory contract or unexpired lease should not, however, 1, 20 ber 2 v m entitle the nonbreaching, nondebtor party to a rightNof e n o specific performance or to ed o v ar retain possession or use of any property of chi debtor or the estate. 363 the -35 o. 14 n, N w A nonbreaching, nondebtor party should be able to retain possession or continue . Bro eth v lixsof the debtor or the estate if expressly authorized by a section of to use property in B cited the Bankruptcy Code (e.g., section 365(n)). If the nondebtor party to an executory contract or unexpired lease breaches the executory contract or unexpired lease prior to the trustee’s assumption or rejection decision, the trustee may treat such contract or lease as breached and exercise any rights or remedies it may have under the contract or lease or applicable nonbankruptcy law. Rejection of Executory Contracts and Unexpired Leases: Background A debtor in possession441 may reject (i.e., disavow) most executory contracts and unexpired leases under section 365(a) of the Bankruptcy Code. A debtor in possession’s decision to reject an executory contract or unexpired lease generally relieves the debtor in possession of further performance obligations under the contract or lease. Courts, however, have differed on whether rejection terminates the contract or lease or, rather, constitutes a breach by the debtor in possession of such contract or lease. 441 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 126 of 402 Bankruptcy Institute Section 365(g) of the Bankruptcy Code specifically provides that rejection “constitutes a breach of such contract or lease.” As such, section 365(g) answers the initial question concerning the effect of rejection and expressly equates rejection with a breach of the contract or lease by the debtor.442 In some cases, that determination may end the inquiry, but in other cases, questions still remain regarding what rights the nondebtor party may pursue under the contract or lease or under applicable nonbankruptcy law because of the debtor’s breach. As explained by the Seventh Circuit in Sunbeam Products, Inc. v. Chicago American Manufacturing, LLC, [w]hat § 365(g) does by classifying rejection as breach is establish that in bankruptcy, as outside of it, the other party’s rights remain in place. After rejecting a contract, a debtor is not subject to an order of specific performance. . . . The debtor’s unfulfilled obligations are converted to damages; . . .  But nothing about this process implies that any rights of the other contracting party have been vaporized.443 Courts and commentators agree that rejection gives the nondebtor party a right to assert monetary damages against the debtor in possession, which is deemed a prepetition claim against the estate.444 They also generally agree that the nondebtor party cannot compel continued performance by the debtor in possession, unless otherwise specifically permitted by section 365.445 They do not, however, agree whether the nondebtor party can enforce equitable remedies against the debtor in possession that such party otherwise would be able to assert under applicable nonbankruptcy law.446 The court’s perspective on this issue can have significant implications for the estate. 016 ,2 er 21 emb Nov d on chive Leases: Rejection of Executory Contracts and Unexpired ar 363 Recommendations and Findingsn, No. 14-35 Brow th v. lixse The Commission focusedinaBsubstantial amount of time on the concept of rejection cited and whether a debtor in possession’s decision to reject an executory contract or unexpired lease should trigger a breach or termination of such contract or lease. The Commissioners discussed the language of section 365 and specifically contrasted it with the chapter 5 avoiding powers of the debtor in possession. Congress did not intend section 365 to operate as an avoiding power that would allow a debtor in possession to terminate or unwind prepetition agreements or completely extinguish the rights of the nondebtor counterparty to an agreement. Such a result would be contrary to the language and structure of the Bankruptcy Code and well-settled federal policy that state law generally determines 442 See, e.g., Sunbeam Prod., Inc. v. Chi. Am. Mfg, LLC, 686 F.3d 372 (7th Cir. 2012), cert. denied, 133 S. Ct. 790 (2012). Both the National Bankruptcy Conference’s Bankruptcy Code Review Project in 1993 and the NBRC in 1997 expressly considered the question of whether rejection should result in termination and provided a negative answer. A.L.I.-A.B.A., Bankruptcy Reform Circa 1993 183–87 (Nat’l Bankr. Conf. 1993); NBRC Report, supra note 37, § 2.4.1. 443 Sunbeam Prod., Inc. v. Chi. Am. Mfg, LLC, 686 F.3d 372, 377 (7th Cir. 2012), cert. denied, 133 S. Ct. 790 (2012). 444 11 U.S.C. § 365(g)(1). 445 See, e.g., In re Walnut Assocs., 145 B.R. 489, 494 (Bankr. E.D. Pa. 1992) (“[N]on-debtor party to the contract subject to rejection is limited in its claims for breach to the treatment accorded to a debtor’s general unsecured creditors. . . . [U]nless specific performance is available to the non-debtor party under applicable state law, the debtor cannot be compelled to render its performances required under the contract. However, if state law does authorize specific performance under the rejected executory contract, it means that the non-debtor should be able to enforce the contract against the Debtor, irrespective of his rejection of it.”). 446 See, e.g., Abboud v. Ground Round, Inc. (In re Ground Round, Inc.), 335 B.R. 253 (B.A.P. 1st Cir. 2005) (“[A] party is entitled to specific performance of a rejected executory contract if such remedy is clearly available under applicable state law.”); In re Annabel, 263 B.R. 19 (Bankr. N.D.N.Y. 2001) (same with respect to covenant not to compete). But see, e.g., In re Register, 95 B.R. 73, 75 (Bankr. M.D. Tenn. 1989) (refusing to enforce covenant not to compete in rejected sale agreement). See also Route 21 Assoc. of Belleville, Inc. v. MHC, Inc., 486 B.R. 75 (S.D.N.Y. 2012) (injunctive relief could be reduced to monetary claim).  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 127 of 402 ABI Commission to Study the Reform of Chapter  property rights in bankruptcy.447 The Commission voted to reinforce the principle that rejection of an executory contract or unexpired lease constitutes a breach, not a termination, of such contract or lease. The Commissioners fully vetted the potential consequences of equating rejection with breach of the applicable contract or lease, using various examples to explore the nuances and variances in possible results. In analyzing these scenarios, the Commissioners worked to balance the state law rights and interests of the nondebtor party with the federal interests that are central to the reorganization efforts of a debtor in possession. These federal interests include equal treatment of all similarly situated creditors, automatic stay of actions based on prepetition transactions and relationships with the debtor, and the ability of the debtor in possession to reject burdensome contracts and leases to facilitate its reorganization.448 The Commission considered the rejection of different kinds of contracts and leases, and identified the competing interests of the debtor in possession and the nondebtor, and the needs of the estate, following rejection. For example, the debtor in possession, on behalf of the estate, needs (i)  any property that may be held by the nondebtor party to be returned; (ii) the ability to use such property free from restraints or limitations; and (iii) relief from any performance obligations under the contract or lease. Congress was aware of these needs and carefully balanced them against the interests of the nondebtor party. In specific instances when the interests of the nondebtor party outweigh the 6 needs of the debtor in possession, Congress specified the nondebtoreparty’s1rights upon rejection. 1, 20 b r2 Specifically, these exceptions arise in the context of certain Novem real property leases, timeshares, and d on 449 chive ar intellectual property licenses. 363 -35 o. 14 n, N w The Commission agreed that, v. Bro than the exceptions already made by Congress, the nondebtor th other lixse in B party to the rejected contract or lease should be required to immediately return the debtor’s property cited to the debtor in possession and should not be able to enforce any equitable or injunctive relief against, or otherwise require performance by, the debtor in possession. In addition to the factors previously noted, the Commissioners pointed to section 542 in support of requiring the counterparty to return personal property to the estate upon rejection.450 They also believed that allowing the nondebtor party to enforce equitable or injunctive relief against the debtor in possession would elevate the rights of such counterparty beyond those of other similarly situated prepetition creditors. Indeed, general unsecured creditors typically are not entitled to relief from the automatic stay or to take actions affecting the debtor in possession’s postpetition business operations, despite the terms of the creditors’ prepetition contracts or applicable nonbankruptcy law. Accordingly, the Commission 447 “Property interests are created and defined by state law. Unless some federal interest requires a different result, there is no reason why such interests should be analyzed differently simply because an interested party is involved in a bankruptcy proceeding.” Butner v. United States, 440 U.S. 48, 54 (1979).  448 See, e.g., In re Am. Suzuki Motor Corp., 494 B.R. 466, 477 (Bankr. C.D. Cal. 2013) (“The purpose of contract rejection under section 365 is to permit the debtor to receive the economic benefits necessary for reorganization (which includes liquidation under chapter 11) for the ultimate benefit of the estate and its creditors. State legislatively imposed buyback requirements, fair market value awards and treble-damages penalties are superimposed onto the normal contract damage remedy provisions under state common or statutory law. While Florida and many other states believe that their public policy should provide special protections for the economic interest of local car dealerships, in the area of federal bankruptcy law those remedies run counter to the federal policy of bankruptcy reorganization and are therefore preempted.”); In re PPI Enters. (U.S.), Inc., 228 B.R. 339, 344– 45 (Bankr. D. Del. 1998) (“In enacting the Bankruptcy Code, Congress made a determination that an eligible debtor should have the opportunity to avail itself of a number of Code provisions which adversely alter creditors’ contractual and nonbankruptcy law rights.”). 449 11 U.S.C. § 365(h), (i), (n). 450 Id. § 542(a) (“[A]n entity . . . shall deliver to the trustee, and account for, such property or the value of such property, unless such property is of inconsequential value or benefit to the estate.”). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 128 of 402 Bankruptcy Institute endorsed the conclusions that rejection should constitute a breach, but it should not (i) deprive the debtor in possession of the right to possess or use estate property or (ii) require specific performance by the debtor in possession or the estate. 4. Intellectual Property Licenses Recommended Principles: A trustee should be able to assume an intellectual property license in accordance with section  365(a) of the Bankruptcy Code notwithstanding applicable nonbankruptcy law or a provision to the contrary in the license or any related agreement. The trustee should be able to assign an intellectual property license to a single assignee in accordance with section 365(f) notwithstanding applicable nonbankruptcy law or a provision to the contrary in the license or any related agreement. If the trustee seeks to assign an intellectual property license under which the debtor is a licensee to a competitor of the nondebtor licensor or an affiliate of such competitor, the court may deny the assignment if the court determines, after notice and a hearing, that the harm to the nondebtor licensor 2016 resulting from the proposed assignment significantly outweighs 1, benefit to ber 2 the vem n o the estate derived from the assignment. The nondebtorN ed o licensor should bear the rchiv burden of proof in any such hearing. 4-35363 a .1 , No rown B and etcopyrights should h v. Blixs Foreign patents be included within the definition of d in “intellectualeproperty” set forth in section 101(35A) and subject to section 365, cit including section 365(n). In addition, foreign trademarks should also be included in this definition, subject to the limitations and conditions imposed on domestic trademarks under the recommended principles in Section  V.A.5, Trademark Licenses. Intellectual Property Licenses: Background A debtor’s or the estate’s assets often include intellectual property. The Bankruptcy Code defines “intellectual property” as a “(A) trade secret; (B)  invention, process, design, or plant protected under title 35 [of the U.S. Code; (C) patent application; (D) plant variety; (E) work of authorship protected under title 17 [of the U.S. Code]; or (F) mask work protected under chapter 9 of title 17; to the extent protected by applicable nonbankruptcy law.”451 In the context of section 365 of the Bankruptcy Code, debtors in possession452 commonly face issues with respect to their ability to assume, assign, or reject their intellectual property licenses.453 451 11 U.S.C. § 101(35A). 452 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. 453 Courts generally characterize intellectual property licenses as executory contracts. In re Kmart Corp., 290 B.R. 614, 618 (Bankr. N.D. Ill. 2003) (“Generally speaking, a license agreement is an executory contract as such is contemplated in the Bankruptcy  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 129 of 402 ABI Commission to Study the Reform of Chapter  A “license” is an agreement that generally allows an owner to monetize the value of its intellectual property. Licenses permit, often for a fee, a third party (licensee) to use the owner’s (licensor’s) intellectual property for a specified purpose, within a specified geographic region, for a specified time period, under specified conditions. Licenses range on a sliding scale from conferring very limited nonexclusive rights to all or essentially all rights to the intellectual property. Licenses are, in essence, a form of covenant by which the licensor agrees not to sue the licensee for using the licensor’s intellectual property. When a debtor in possession is the licensee under an intellectual property license, two potentially competing federal interests are at play: (i) the Bankruptcy Code generally allows the debtor in possession to unilaterally decide whether to assume, assign, or reject an executory contract; and (ii)  the federal law on intellectual property licenses respects the right of the licensor to control its intellectual property.454 Some courts have turned to section 365(c) of the Bankruptcy Code to address this potential conflict. Section 365(c) generally restricts the ability of a debtor in possession to assume or assign if “applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties.”455 Such contracts can be assumed or assigned by the debtor in possession only with the consent of the nondebtor party to the contract. 6 1 Courts applying section 365(c)(1) to the rights of a debtor in possession 0as a licensee under an 1, 2 ber 2 ve intellectual property license are split regarding whether a odebtorm possession may assume (i.e., n No in ed a assigning the license to a third party, without keep and perform under) the license, as opposed3torchiv 3536 . 14- that permit a debtor in possession to assume a license the consent of the nondebtor licensor., Courts No own v. Brthe “actual approach,” which treats the debtor in possession as the under these circumstances eth follow Blixs same entity to which ithe third party licensor extended the license in the first instance.456 Because the ed n cit identity of the parties has not changed under this theory and the action would not be deemed an impermissible assignment under applicable nonbankruptcy law, these courts authorize the debtor in possession to assume such license under section 365(a) and (b). Other courts, however, find the actual test in contravention of the statutory language. These courts follow the “hypothetical approach,” which preclude the debtor in possession from assuming an agreement if applicable nonbankruptcy law would preclude the debtor from assigning the license to a third party, even if the debtor in possession has no intention of effecting such an assignment.457 Some commentators have criticized the hypothetical approach as providing the nondebtor licensor Code.’”) (citations omitted). 454 See Unarco Indus., Inc. v. Kelley Co., Inc., 465 F.2d 1303, 1306 (7th Cir. 1972), cert. denied, 410 U.S. 929 (1973) (citations omitted) (“[L]ong standing federal rule of law with respect to the assignability of patent licenses provides that these agreements are personal to the licensee and not assignable unless expressly made so in the agreement.”). 455 11 U.S.C. § 365(c)(1). 456 The First and Fifth Circuits adopted the “actual test.” In re Mirant Corp., 440  F.3d 238 (5th Cir. 2006); Institut Pasteur v. Cambridge Biotech Corp., 104 F.3d 489 (1st Cir. 1997), abrogated by Hardemon v. City of Boston, 1998 WL 148382 (1st Cir. Apr. 6, 1998), superseded by 144 F.3d 24 (1st Cir. 1998). See also In re Footstar, Inc., 323 B.R. 566 (Bankr. S.D.N.Y. 2005) (taking a slightly different approach but holding that section 365(c)(1)’s use of the word “trustee” does not include the debtor or debtor in possession when assumption is sought because assumption does not require the nondebtor party to accept performance from a new party other than the debtor or debtor in possession). 457 The Third, Fourth, Ninth, and Eleventh Circuits have adopted the “hypothetical test.” In re Sunterra Corp., 361 F.3d 257 (4th Cir. 2004); In re Catapult Entm’t, Inc., 165 F.3d 747 (9th Cir. 1999); In re James Cable Partners, L.P., 27 F.3d 534 (11th Cir. 1994); In re West Elec. Inc., 852 F.2d 79 (3d Cir. 1988). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 130 of 402 Bankruptcy Institute with holdup power that can frustrate or completely derail the reorganization efforts of the debtor in possession.458 Conversely, when a debtor in possession is the licensor under an intellectual property license and decides to reject the license, section 365(n) of the Bankruptcy Code allows the nondebtor licensee to treat the license as either (i) terminated, or (ii) effective through the end of the remaining term. If the licensee elects to retain the license, it cannot compel any performance by the debtor, but it retains the ability to use certain of its rights under the license for the remaining term, for which it must continue to pay any royalties or other fees required by the terms of the license. Additionally, the nondebtor licensee may not assert any damages for nonperformance by the debtor through a setoff against any fees or payments it owes under the license. Notably, the definition of intellectual property does not include foreign intellectual property or trademarks, which often poses an issue under section 365(n). In the context of trademarks, the issue is particularly challenging when the trademarks are integrated into a license with intellectual property (as that term is currently defined under the Bankruptcy Code). The treatment of trademarks under section 365 is addressed separately in the following section. Intellectual Property Licenses: Recommendations and Findings Intellectual property licenses can represent valuable assets of the estate and may be6necessary to the 01 reorganization of the debtor in possession. Thus, the treatment of these ber 21, 2 under section 365 licenses em n case. of the Bankruptcy Code is often a critically important issue indthe Nov The Commission reviewed e o hiv open issues relating to intellectual property licenses 363chapter 11. in arc -35 . 14 , No rown v. B The Commissioners evaluated seth statutory interpretation x the n Bli i between supporters ofethe hypothetical approach, on the cit d and practical issues raised by the debate one hand, and supporters of the actual approach, on the other hand, concerning the ability of a debtor in possession (as licensee) to assume (i.e., keep and use) an intellectual property license without the consent of the nondebtor party (as licensor).459 The Commissioners acknowledged that nondebtor licensors may have legitimate concerns about providing their intellectual property to a party other than the debtor, but those concerns should not exist when the debtor in possession proposes to assume and perform in accordance with the license. In those instances, the licensor would be receiving the benefit of its bargain. The Commissioners recognized that application of the hypothetical test results in artificial barriers to the reorganization of the debtor in possession — an outcome that directly undercuts a fundamental policy underlying the Bankruptcy Code. The Commission voted to reject the hypothetical approach and to adopt and codify the actual approach. The Commission further recommended that Congress amend the Bankruptcy Code to expressly authorize the debtor in possession to assume executory intellectual property licenses. 458 See, e.g., David R. Kuney, Intellectual Property in Bankruptcy Court: The Search for a More Coherent Standard in Dealing with a Debtor’s Right to Assume and Assign Technology Licenses, 9 Am. Bankr. Inst. L. Rev. 593 (2001). 459 See Written Statement of Robert L. Eisenbach III, Partner, Cooley LLP: NYIC Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 3–6 (June 4, 2013) (discussing the tests in practical terms), available at Commission website, supra note 55; Written Statement of Lisa Hill Fenning, Partner, Arnold & Porter LLP: NYIC Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 3–6 (June 4, 2013) (discussing impact of bankruptcy law on intellectual property licenses), available at Commission website, supra note 55.  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 131 of 402 ABI Commission to Study the Reform of Chapter  The Commissioners also critically analyzed whether the result of the hypothetical test (i.e., no assumption without the consent of the nondebtor licensor) was good policy in the actual assignment context. Admittedly, the ability to exclude others from using your intellectual property is a key element of intellectual property ownership. This right provides intellectual property owners some control over the use of their property and a means to monetize at least some of the value of their property. The assignment by the debtor in possession of an intellectual property license, in accordance with the terms of section 365(f) (requiring, among other things, adequate assurance of future performance and assumption of the entire agreement), arguably does not significantly decrease the value of the licensor’s right to exclude users. The Commissioners debated the advantages and disadvantages of providing debtors in possession with more flexibility to assign intellectual property licenses under the Bankruptcy Code. Some of the Commissioners believed that this flexibility was necessary to maximize the value of the estate and to facilitate certain reorganization transactions. In considering the value of the license from both the licensor’s and licensee’s perspectives, they observed that U.S. assignment laws are more restrictive than those in many foreign jurisdictions.460 Moreover, many of the Commissioners did not believe that the identity of the debtor, absent unusual circumstances, was per se a critical factor in the licensing relationship. Rather, factors such as the licensee’s ability to pay, to maintain the desired integrity and quality of the intellectual property, and to comply with all obligations imposed by the license are likely more relevant and important. 16 1, 20 ber 2 ve could be critical if the proposed The Commissioners acknowledged that the identity of the licenseem n No ed o rchiv assignee was a competitor of the licensor. In thoseainstances, nondebtor licensors should have the 63 -353 14 ability to block a proposed assignment, by the debtor licensee. The Commission supported a proposal No. rown that would permit a debtorthin. B e v possession to assign an intellectual property license freely under Blixs n (2), subject to a nondebtor licensor’s right to demonstrate that the hardship i section 365(f)(1)itand c ed imposed on it by the proposed assignment to one of its competitors would significantly outweigh the benefit to the estate. The Commission also reviewed the exclusion of foreign patents and copyrights from the definition of intellectual property in section 101(35A) of the Bankruptcy Code. Foreign patents and copyrights are excluded from this definition because they are not covered by title 35 or title 17 of the U.S. Code. The Commissioners believed that licenses for foreign patents, copyrights and trademarks (subject to the limitations proposed for U.S. trademarks below), although generally not governed by U.S. law, should receive the same treatment in bankruptcy as U.S. licenses. Moreover, licensees under licenses of foreign intellectual property should receive the same protections as licensees under U.S. licenses pursuant to section 365(n) of the Bankruptcy Code. The Commission found no reasonable basis for treating foreign intellectual property differently. 460 See, e.g., M. Reutter, Intellectual Property Licensing Agreements and Bankruptcy, in Research Handbook On Intellectual Property Licensing 281 (Jacques de Werra ed., 2013). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 132 of 402 Bankruptcy Institute 5. Trademark Licenses Recommended Principles: “Trademarks,” “service marks,” and “trade names,” as defined in section 1127 of title 15 of the U.S. Code, should be included in the definition of “intellectual property” under the Bankruptcy Code. Section 101(35A) of the Bankruptcy Code should be amended accordingly. If a debtor is a licensor under a trademark, service mark, or trade name license and the trustee elects to reject that license under section 365, section 365(n) should apply to the license, with certain modifications. The nondebtor licensee should be required to comply in all respects with the license and any related agreements, including with respect to (i) the products, materials, and processes permitted or required to be used in connection with the licensed trademark, service mark, or trade name; and (ii) any of its obligations to maintain the sourcing and quality of the products or services offered under or in connection with the licensed trademark, service mark, or trade name. The trustee should maintain the right to oversee and enforce quality control for such products or services and should not be under any continuing obligation to provide products or services to the rejected 16 licensee. In addition, the concept of “royalty payments” under 2section 365(n) 1, 20 ber vem should be expanded to include “other payments” contemplated by the trademark, n No ed o rchiv service mark, or trade name license. 63 a 53 14-3 No. wn, . Bro eth v Blixs i Trademark Licenses:n Background cited As noted above, trademarks are not included in the definition of “intellectual property” under section 101(35A) of the Bankruptcy Code. Congress made the conscious decision in the 1988 amendments to exclude this kind of intangible property because trademarks have slightly different characteristics as compared to other intangible property that is included in the definition of intellectual property. One key difference is that any transfer of a trademark, including a license or assignment, must include a transfer of the associated business operations (referred to as “good will” under applicable nonbankruptcy law).461 In addition, trademark licenses raise other challenges, as explained by the legislative history of Bankruptcy Code section 365(n): 461 The relevant portion of the Lanham Act provides: (1) A registered mark or a mark for which an application to register has been filed shall be assignable with the good will of the business in which the mark is used, or with that part of the good will of the business connected with the use of and symbolized by the mark. Notwithstanding the preceding sentence, no application to register a mark under section 1051(b) of this title shall be assignable prior to the filing of an amendment under section 1051(c) of this title to bring the application into conformity with section 1051(a) of this title or the filing of the verified statement of use under section 1051(d) of this title, except for an assignment to a successor to the business of the applicant, or portion thereof, to which the mark pertains, if that business is ongoing and existing. (2) In any assignment authorized by this section, it shall not be necessary to include the good will of the business connected with the use of and symbolized by any other mark used in the business or by the name or style under which the business is conducted. 15 U.S.C. § 1060(a).   V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 133 of 402 ABI Commission to Study the Reform of Chapter  [T]he bill does not address the rejection of executory trademark, trade name or service mark licenses by debtor licensors. While such rejection is of concern because of the interpretation of section 365 by the Lubrizol court and others, such contracts raise issues beyond the scope of this legislation. In particular, trademark, trade name and service mark licensing relationships depend to a large extent on control of the quality of the products or services sold by the licensee. Since these matters could not be addressed without more extensive study, it was determined to postpone congressional action in this area and to allow the development of equitable treatment of this situation by bankruptcy courts.462 Several commentators have discussed the uncertainty created for nondebtor licensees of a debtor’s trademarks given the exclusion of trademarks from the definition of intellectual property and section 365(n). Courts have struggled with the treatment of trademark licenses and the consequences of rejection pursuant to section 365 by a debtor licensor of a license with a nondebtor licensee.463 Some courts have determined that the rejection of such an agreement terminates the nondebtor licensee’s rights to use the relevant trademarks and any associated goodwill, and grants the nondebtor party only the right to file a claim for monetary damages against the estate.464 Other courts have determined that the debtor in possession’s465 rejection of a license constitutes only a breach of such agreement, which is consistent with section 365(g), and that the nondebtor licensee may continue to exercise its rights under the rejected agreement consistent with applicable nonbankruptcy law.466 In addition, 16 1, 0 some courts have determined that trademark licenses are not executory2contracts and therefore ber 2 m Nove cannot be rejected.467 d on ive arch 363 -35 o 14 Similar to other intellectual property,Na . trademark license may be an integral component of a n, Brow nondebtor’s business — particularly in the franchising context. In the event that a licensor files for th v. lixse in B bankruptcy, a bankruptcy provision that automatically strips the nondebtor licensee of all rights to cited use the debtor’s trademarks and any associated goodwill upon the debtor in possession’s rejection of the trademark license could devastate the nondebtor’s business. Conversely, the ability of the debtor in possession to reorganize successfully may hinge, at least in part, on its ability to repossess 462 S. Rep. No. 100–505, at 5 (1988), reprinted in 1988 U.S.C.C.A.N. 3204 (citations omitted). 463 See, e.g., In re Old Carco LLC, 406 B.R. 180, 211 (Bankr. S.D.N.Y. 2009), aff ’d sub nom. Mauro Motors Inc. v. Old Carco LLC, 420 F. App’x 89 (2d Cir. 2011) (“Trademarks are not ‘intellectual property’ under the Bankruptcy Code . . . [, so] rejection of licenses by licensor deprives licensee of right to use trademark. . . .”); In re HQ Global Holdings, Inc., 290 B.R. 507, 513 (Bankr. D. Del. 2003) (“[S]ince the Bankruptcy Code does not include trademarks in its protected class of intellectual property, Lubrizol controls and the Franchisees’ right to use the trademark stops on rejection.”); In re Centura Software Corp., 281 B.R. 660, 674–75 (Bankr. N.D. Cal. 2002) (“Because Section 365(n) plainly excludes trademarks, the court holds that [licensee] is not entitled to retain any rights in [licensed trademarks] under the rejected . . . Trademark Agreement.”). 464 See Lubrizol Enters., Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043, 1048 (4th Cir. 1985) (no right to continue to use mark upon rejection). Such a claim is treated as an unsecured prepetition claim. 465 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. 466 See Sunbeam Prods., Inc. v. Chi. Am. Mfg., LLC, 686 F.3d 372, 377 (7th Cir. 2012), cert. denied, 133 S. Ct. 790 (2012) (holding that Lubrizol was wrongly decided and that the transfer of rights embodied in trademark or other IP licenses could not be “vaporized” by rejection). “[R]ejection is not the ‘functional equivalent of a rescission, rendering void the contract and requiring that the parties be put back in the position they occupied before the contract was formed.’ It ‘merely frees the estate from the obligation to perform’ and ‘has absolutely no effect upon the contract’s continued existence.’” Id. (citations omitted). 467 See also In re Exide Techs., 607 F.3d 957 (3d Cir. 2010) (trademark license not executory and not subject to rejection under facts of case). Courts may use § 365 to free a bankrupt trademark licensor from burdensome duties that hinder its reorganization. They should not — as occurred in this case — use it to let a licensor take back trademark rights it bargained away. This makes bankruptcy more a sword than a shield, putting debtor-licensors in a catbird seat they often do not deserve. Id. at 967–68. But see In re New York City Shoes, Inc., 84 B.R. 947, 960 (Bankr. E.D. Pa. 1988) (exclusive trademark licensing agreement providing for annual royalties was executory). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 134 of 402 Bankruptcy Institute its trademarks and any associated goodwill and then redeploy these assets in a more productive manner consistent with its reorganization efforts. Trademark Licenses: Recommendations and Findings The Commission considered whether adding trademarks to the definition of intellectual property under section 101(35A) of the Bankruptcy Code was a workable solution. Several Commissioners noted that the concerns underpinning the decision by Congress in the 1988 amendments to exclude trademarks from the definition of intellectual property still persist. Generally, applicable nonbankruptcy law continues to treat trademarks differently in comparison to other intangible property. These Commissioners did not believe that the process provided in section 365(n) would necessarily work for all trademark licenses or generate the fair result — considering both the interests of the estate and the nondebtor licensee — in every case. The Commissioners recognized, however, the uncertainty surrounding the treatment of trademark licenses in chapter 11 cases. They discussed how these licenses, to the extent they are deemed executory contracts under the Bankruptcy Code, would be treated under the recommended principles for rejection of executory contracts and leases.468 For example, the rejection of the trademark license would constitute a breach by the debtor. It would not terminate the license or eviscerate the nondebtor licensee’s rights under the license. The rejection likely would require, however, the 016 nondebtor licensee to turn over the right to use the trademark and any ber 21, 2 goodwill to the associated m No e estate. Moreover, the nondebtor licensee would not be able toerequirevperformance by the debtor in d on hiv possession or seek equitable or injunctive relief. -35363 arc . 14 , No rown .B The Commission consideredxswhether section 365(n) could be modified to accommodate the eth v n Bli i unique attributes of trademark licenses and the related concerns of both the debtor licensor and the cited nondebtor licensee. The Commissioners discussed the advantages and disadvantages of including trademarks within the definition of intellectual property under the Bankruptcy Code. Some Commissioners believed that such inclusion was problematic because of the goodwill associated with the marks and the frequent need of trademark licensees to have access to the related products or goods, or components thereof, to utilize the marks legitimately under the license. Moreover, these Commissioners raised concerns about a debtor licensor’s need to monitor quality control of the use of any marks by a licensee. Other Commissioners believed that the statute could incorporate appropriate protections and limitations to protect debtor licensors and mitigate the valid concerns regarding goodwill and ongoing compliance with the license by the licensee. The Commissioners expressed concern about the ongoing ambiguity surrounding trademarks in bankruptcy, and the related costs imposed on a debtor in possession and the estate, as well as the potential harm to the nondebtor licensee’s business. After considering the alternatives and the 2014 Innovation Act proposed in Congress,469 the Commission determined that trademark licenses should be included in the definition of intellectual property licenses under the Bankruptcy Code. In reaching this conclusion, the Commission agreed 468 See Section V.A.3, Rejection of Executory Contracts and Unexpired Leases. 469 See Innovation Act of 2013, H.R. 3309, 113th Cong. § 6(d) (1st Sess. 2013), available at https://www.congress.gov/113/bills/ hr3309/BILLS-113hr3309rfs.pdf.  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 135 of 402 ABI Commission to Study the Reform of Chapter  that section 365(n) should be amended to address certain unique aspects of trademark licenses, including a provision that would allow a debtor in possession to monitor quality control, but otherwise not impose obligations on the debtor in possession if the license is rejected. The Commission also agreed that section 365(n) needs to expressly require a nondebtor licensee electing to retain its rights under the trademark license to comply in all respects with the license and any related agreements, including with respect to (i) the products, materials, and processes permitted or required to be used in connection with the licensed marks; and (ii) any of its obligations to maintain the sourcing and quality of the products or services offered under or in connection with the licensed marks. 6. Real Property Leases Recommended Principles: The trustee’s time to assume or reject unexpired nonresidential real property leases under section 365(d)(4) of the Bankruptcy Code should be extended from 210 days to one year after the petition date or date of the order for relief, whichever is later, in the interest of enhancing prospects for reorganization. The calculation of postpetition rent under a real property lease should be calculated under the accrual method, allowing the trustee to treat rent accrued prior to the 16 1 20 petition date as a prepetition claim and rent accruedeon eand, after the petition b r2 v m n No date as a postpetition obligation. The trusteeivshould be required to pay any such ed o rch postpetition rent obligation on or -35363 a before 30 days after the petition date or date of . 14 ,N the order for relief, whicheverois later. The trustee should pay all subsequent rent rown .B eth v obligationsnaccruing postpetition but prior to any rejection of the lease on a timely Blixs di ci accordance with the terms of the lease. basis inte A landlord’s claim for unperformed obligations under section 365(d)(3) should apply only to monetary obligations. Such claim for unperformed monetary obligations should not receive superpriority treatment, but should instead constitute an administrative claim under section 503(b)(1) that is payable under section 507(a)(2). The meaning of the term “rent” under section 502(b)(6) should not be based on whether an obligation is labeled as “rent” under the lease. Rather, the Bankruptcy Code should define “rent” as any recurring monetary obligations of the debtor under the lease. The calculation of rejection damages for real property leases under section 502(b) (6) should be clarified as follows: The claim of a lessor for damages resulting from the termination of a lease of real property shall not exceed: (i) The greater of (A) the rent reserved for one year under the lease following the termination date and (B) the alternative rent calculation; plus (ii) Any unpaid rent due under the lease on the termination date. V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 136 of 402 Bankruptcy Institute For purposes of this section: The “alternative rent calculation” is the rent reserved for the shorter of the following two periods: (a) 15 percent of the remaining term of the lease following the termination date and (b) three years under the lease following the termination date. The “termination date” is the earlier of the petition date and the date on which the lessor repossessed, or the lessee surrendered, the leased property. In calculating the rent due or reserved under the lease, such calculation should be done without acceleration. A landlord should be required to make reasonable efforts to mitigate damages in the event that the trustee rejects the lease under section 365, regardless of whether mitigation is required by applicable nonbankruptcy law. Any mitigation or cover received by, or security deposit held by, the landlord should reduce the landlord’s prepetition claim for purposes of calculating the section 502(b)(6) claim. A landlord’s obligation to mitigate damages should continue through the claims objection deadline or the date of the order allowing the claim, whichever is earlier. A landlord’s claims for the debtor’s acts and omissions resulting in 0damage to 6 ,2 1 the real property, other than those claims relating to the rejection 1 the lease or ber 2 of vem n No for rent under the lease, should not be subject to isection 502(b)(6). The landlord ed o rch v 63 a should be permitted to assert any such3claim as a prepetition claim against the - 53 o. 14 estate, subject to the trustee’srown, N or a party in interest’s right to object and the general B h v. xset claims allowance process. n Bli i cited Real Property Leases: Background Many chapter 11 debtors have one or more unexpired leases of nonresidential real property as of the petition date. These leases may be for the debtor’s headquarters, stores, warehouses, or factories. They may be necessary to the debtor in possession’s470 reorganization efforts or otherwise represent valuable assets that the debtor in possession can use to maximize the value of the estate. Alternatively, they may be above-market leases or used in a part of the business being closed or downsized through the reorganization. In either scenario, a debtor in possession’s ability to assume, assign, or reject unexpired leases of nonresidential real property is important to the resolution of its case. The Bankruptcy Code includes several provisions that specifically address the rights and obligations of the debtor in possession and the nondebtor landlord under unexpired leases of nonresidential real property leases. For example, section 365(d)(3) requires the debtor in possession to timely perform obligations “arising from and after the order for relief under any unexpired lease of nonresidential real 470 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model.  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 137 of 402 ABI Commission to Study the Reform of Chapter  property, until such lease is assumed or rejected.”471 In addition, section 365(d)(4) requires the debtor in possession to assume or reject any nonresidential real property lease within 120 days after the petition date, with one 90-day extension of that deadline for cause.472 The debtor in possession generally is given until plan confirmation to assume or reject executory contracts and other kinds of leases.473 Commentators and practitioners have raised issues concerning several of these provisions. Many commentators have criticized the shortened deadline for the debtor in possession to assume, assign, or reject a nonresidential real property lease under section 365(d)(4) of the Bankruptcy Code.474 Prior to the BAPCPA Amendments, a debtor in possession had an initial 60 days to review its unexpired nonresidential leases, but it could obtain one or more extensions of this deadline for cause and with court approval.475 Some commentators and landlords believed that courts were granting debtors in possession very lengthy extensions of the section 365(d)(4) deadline on a routine basis.476 They believed that these open-ended extensions significantly impaired the landlords’ rights under the leases and nonbankruptcy law, as well as their ability to identify substitute lessees and negotiate substitute leases in a timely manner.477 As a result of the BAPCPA Amendments, section 365 provides a debtor in possession with 210 days following the petition date to decide whether it will assume or reject each of its nonresidential real property leases, unless the applicable landlord consents to an extension of this deadline. Some commentators suggested, immediately following the BAPCPA Amendments, that this single change 16 to the Bankruptcy Code would discourage large retail chains from filingr chapter 11 petitions.478 Large 1, 20 be 2 retail chains, in particular, frequently have hundreds of unexpired em Novnonresidential real property leases d on hive cand making prudent assumption or rejection r as of the petition date, and the prospect of reviewing 63 a -353 . 14of the petition date, according to these commentators, decisions for each location within 210 No , days own v. Br would likely be too dauntingth thus discourage filings in the first place.479 Empirical and anecdotal e and Blixs evidence since 2005 isuggests that this change in a debtor in possession’s time to assume or assign ed n cit nonresidential real property leases is at least a contributing factor to both the decline in retail filings and the results that were achieved in certain retail debtor cases since 2005.480 471 472 473 474 475 476 477 478 479 480 11 U.S.C. § 365(d)(3). Id. § 365(d)(4). Id. § 365(d)(2). Id. § 365(d)(4). Circuit City Unplugged: Why Did Chapter 11 Fail to Save 34,000 Jobs?, Hearing before the H. Subcomm. on Commercial and Administrative Law, 111th Cong. 96 (2009) (statement of Professor Jack F. Williams, Robert M. Zinman ABI Resident Scholar (2008–09)) [hereinafter Williams Statement]. See, e.g., Written Statement of Elizabeth Holland on behalf of the International Council of Shopping Centers: NYIC Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 2 (June 4, 2013) (discussion prior law), available at Commission website, supra note 55. See generally Transcript, NYIC Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, available at Commission website, supra note 55. “The deadline was originally enacted to address problems caused by extended vacancies or partial operation by a debtor of tenant space located in shopping centers which reduced customer traffic to other nondebtor tenants due to delays in debtors deciding whether to assume or reject real property leases.” In re FPSDA I, LLC, 450 B.R. 392, 399 (Bankr. E.D.N.Y. 2011). See, e.g., Williams Statement, supra note 475, at 97 (“Professor Ken Klee suggests one other possible outcome — retail debtors with a significant number of leases will simply refuse to file voluntary petitions during slower periods and will instead wait to be forced into involuntary cases.”) (citations omitted). See, e.g., id. at 96–97; Written Statement of John Collen, Partner, Tressler LLP: NCBJ Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 2–3 (Apr. 26, 2012) (stating that 210 days may not be sufficient for a debtor to make an informed decision), available at Commission website, supra note 55; Written Statement of Commercial Finance Association: CFA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 8 (Nov. 15, 2012) (stating that the 210-day period to assume or reject a nonresidential lease is too short, discourages reorganization, and impairs secured creditor recoveries), available at Commission website, supra note 55. See Kenneth Ayotte, An Empirical Investigation of Leases and Executory Contracts, (paper presented at 2014 symposium) (draft on file with Commission) (finding that BAPCPA is “associated with a significantly lower probability of reorganization for the most lease-intensive firms”). See also Written Statement of Gerald Buccino: TMA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 5 (Nov. 3, 2012) (arguing that the 210-day period is insufficient, particularly for retail debtors), available V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 138 of 402 Bankruptcy Institute Courts also take different approaches to calculating the timely payments a debtor in possession is obligated to make under its nonresidential real property leases pursuant to section  365(d)(3). Some courts determine the prepetition or postpetition status of rent amounts owed by a debtor in possession using a billing approach based on the landlord’s invoice date.481 Other courts take an accrual approach and allocate the outstanding amounts between the prepetition and postpetition periods accordingly.482 Courts also differ on the priority accorded to any unpaid postpetition amounts due under section 365(d)(3).483 Similarly, if a debtor in possession rejects a nonresidential real property lease, the landlord’s claim for rejection damages is generally subject to the cap provided by section 502(b)(6) of the Bankruptcy Code. Section 502(b)(6) generally “limits a landlord’s ‘damages resulting from the termination of a lease of real property’ to an amount equal to the rent the debtor-tenant would have paid for a period of one to three years, depending on the remaining term of the lease.”484 The calculation of the section 502(b)(6) cap, as well as what constitutes rent or otherwise should be included in the calculation, often produces litigation and uncertain results in chapter 11 cases.485 Notably, courts are split regarding the application of the section 502(b)(6) cap to nontermination damages relating to the lease, which could constitute millions of dollars and significantly impact unsecured creditors’ pro rata share of estate assets.486 16 1, 20 ber 2 vem n No ed o rchiv 63 a -353 o. 14 n, N r Statement of Elizabeth Holland on behalf of the International Council of Shopping at Commission website, supra note 55; Writtenow v. B Centers: NYIC Field Hearing Before theth Comm’n to Study the Reform of Chapter 11, at 4–5 (June 4, 2013) (testifying that the xse ABI n Bli primary problem in retail d i reorganizations is lender control and stating that “[l]enders are sometimes willing to provide only cite 481 482 483 484 485 486  enough financing to position a debtor for liquidation in the first few months of the case, and then impose restrictive covenants in post-petition financing agreements that either direct an immediate liquidation of the company, or include covenants or borrowing reserve rights that effectively allow the lender to ‘pull the plug’ on the retailer only a few months into the case”), available at Commission website, supra note 55; Written Statement of Lawrence C. Gottlieb, Partner, Cooley LLP: NYIC Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 4–5 (June 4, 2013) (explaining the tension in the timing regarding the desire of the secured creditor to liquidate the debtors’ assets and the ability of the debtor to effectively conduct going-out-of-business (“GOB”) sales at its retail locations; given the 210-day limit set by BAPCPA and given the fact that a GOB sale takes at least 120 days in most cases, the debtor has 30 to 90 days to sell its company; landlords are also unwilling to negotiate, which increases the prevalence of quick liquidations in retail cases), available at Commission website, supra note 55; Written Statement of Holly Felder Etlin: ASM Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 2–3 (Apr. 19, 2013) (stating that the 210-day limit to assume or reject nonresidential leases puts retailers in a timing pinch; because GOB sales generally take at least 120 days and must take place in their retail locations, the 210-day limit to assume or reject leases puts inordinate pressure on debtors to decide within 90 to 120 days after filing to either quickly file a chapter 11 plans while complying with all their lenders’ requirements, or to liquidate; also stating that the 210-day deadline to assume or reject nonresidential leases means it is nearly impossible for a middle-market retail company to do anything but conduct a GOB sale), available at Commission website, supra note 55. See Centerpoint Props. v. Montgomery Ward Holding Corp. (In re Montgomery Ward Holding Corp.), 268 F.3d 205, 209–10 (3d. Cir. 2001); Written Statement of Elizabeth Holland on behalf of the International Council of Shopping Centers: NYIC Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 6–8 (June 4, 2013) (describing how this “stub rent” problem means that landlords are, perhaps unfairly, losing money because of the timing of debtors’ bankruptcy filings), available at Commission website, supra note 55. See In re Stone Barn Manhattan LLC, 398 B.R. 359, 362–65 (Bankr. S.D.N.Y. 2008) (using the accrual method but providing historical overview and case cites of the accrual versus billing date approach). Compare In re Oreck Corp., 506 B.R. 500 (Bankr. M.D. Tenn. 2014) (holding that debtor’s obligation to pay occurred prepetition was not subject to priority treatment) with In re Leather Factory Inc., 475 B.R. 710 (Bankr. C.D. Cal. 2012) (holding that “stub rent” owed to landlord was a priority administrative claim). 11 U.S.C. § 502(b)(6); Michael St. Patrick Baxter, The Application of § 502(b)(6) to Nontermination Lease Damages: To Cap or Not to Cap?, 83 Am. Bankr. L. J. 111 (2009). See, e.g., In re Heller Ehrman LLP, 2011 WL 635224 (N.D. Cal. Feb. 11, 2011) (discussing challenges in determining remaining term of lease); In re Titus & McConomy, LLP, 375 B.R. 165 (Bankr. W.D. Pa. 2007) (holding that, because one year’s rent was greater than 15 percent of remaining term of lease following petition date, section 502(b)(6)(A) determined amount of cap was equal one year’s rent). Baxter, supra note 484, at 113–14. V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 139 of 402 ABI Commission to Study the Reform of Chapter  Real Property Leases: Recommendations and Findings The Commission reviewed several issues relating to nonresidential real property leases. Several Commissioners voiced strong concerns regarding the shortened deadline for a debtor in possession to assume or reject nonresidential real property leases under section 365(d)(4). The Commissioners suggested that the current deadline is preventing potential debtors from using chapter 11, at least on a voluntary and timely basis, and is making it more difficult for retail chains to reorganize their businesses.487 The Commissioners also noted that the 210-day deadline is misleading because postpetition lenders have been requiring debtors in possession to make their decisions about nonresidential real property leases as early as 120 to 150 days after the petition date to permit these lenders to preserve their security interests in the debtors’ leaseholds before the expiration of the section 365(d)(4) deadline.488 Other Commissioners, while acknowledging these troubling facts, emphasized the need to balance the concerns raised by landlords before the BAPCPA Amendments when courts were granting very lengthy extensions.489 They encouraged the Commission to find a compromise that would provide more flexibility to debtors in possession to secure financing and to review their unexpired leases within a reasonable time frame without eliminating the certainty that section 365(d)(3) currently 487 See, e.g., Sharon Bonelli, Isabel Hu, Gregory Fodell, U.S. Retail Case Studies in Bankruptcy Enterprise Value and Creditor Recoveries, Fitch Ratings, Apr. 16, 2013; Written Statement of Lawrence Gottlieb, Partner, Cooley LLP: NYIC Field Hearing Before 16 the ABI Comm’n to Study the Reform of Chapter 11, at 3 (June 4, 2013) (“The deadline established under BAPCPA for a debtor 1, 20 ber 2 to assume or reject unexpired leases of nonresidential property has had a substantial and unfortunate affect on retailers’ ability vem n No to meet liquidity needs and obtain extended postpetition financing —dthe lynchpin to any successful retail reorganization.”), e o Buccino: TMA Field Hearing Before the ABI Comm’n available at Commission website, supra note 55; Written StatementcofiGerald r hv 63 a to Study the Reform of Chapter 11 (Nov. 3, 2012) (noting that the maximum time limit to assume or reject nonresidential real -353 4 property leases should be amended, as it takes No. 1 thoroughly assess whether a lease should be maintained for the value of , time to rown reorganization efforts), available at Commission website, supra note 55; Oral Testimony of Grant Stein: AIRA Field Hearing Before v. B the ABI Comm’n to Study the seth of Chapter 11, at 3 (June 7, 2013) (AIRA Transcript) (noting that the court should allow x Reform n Bli or rejection if it is appropriate in the circumstances), available at Commission website, supra note i more time for the iassumption c ted 55; First Report of the Commercial Fin. Ass’n to the ABI Comm’n to Study the Reform of Chapter 11: Field Hearing at Commercial Fin. Ass’n Annual Meeting, at 8–9 (Nov. 15, 2012) (“Debtors and their secured and unsecured creditors must make decisions about whether to retain leases in a period of time that is often unrealistically short. As a result, businesses that might have been reorganized or sold as going concerns to new owners are liquidated instead. Because they know that debtors with significant leases will have difficulty reorganizing, lenders are less willing to support reorganizations with DIP financing. They do not want to begin lending money to a chapter 11 debtor only to have to choose, 7 months later, between agreeing to an unfavorable deal with a landlord that has such significant leverage and liquidating the debtor, possibly at a loss to the lender. So they simply refuse to provide DIP financing in the first place, forcing debtors to liquidate before they have had an opportunity to make operational changes, regardless of the potential for reorganization. In addition, going concern asset sales (a frequent form of ‘reorganization’ without a plan) become more difficult and less advantageous to creditors and owners because buyers have insufficient time to assess the value of an enterprise with important leases. Uncertainty about value always results in lower prices and therefore lower payments to creditors. Worse, such uncertainty can render going concern sales so difficult that they are not even pursued, again resulting in otherwise avoidable liquidations.”), available at Commission website, supra note 55. 488 See Written Statement of Lawrence C. Gottlieb, Partner, Cooley LLP: NYIC Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 4–5 (June 4, 2013) (stating that the deadline should be expanded to allow time for a debtor to secure postpetition financing and conduct a going-out-of-business sale and stating that prepetition lenders often demand provisions that result in a liquidation sale before the expiration of the 210-day period), available at Commission website, supra note 55. But see Written Statement of David L. Pollack, Partner, Ballard Spahr LLP: NYIC Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 2–3 (June 4, 2013) (stating that neither section 365(d)(4) time limits nor commercial landlords are causing retailers to fail and providing specific case examples to support assertion; also noting that retailers are failing because of other reasons, such as DIP financing conditions and reluctance of trade creditors to continue to extend credit), available at Commission website, supra note 55. See also Ayotte, An Empirical Investigation of Leases and Executory Contracts, supra note 480 (finding that the seven-month limit to assume or reject a commercial lease instituted by BAPCPA (absent an extension from the landlord) “accelerated real estate lease disposition decisions”). See generally supra note 66 and accompanying text (generally discussing limitations of chapter 11 empirical studies). 489 See, e.g., Written Statement of Elizabeth Holland on behalf of the International Council of Shopping Centers: NYIC Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 2 (June 4, 2013) (“The 2005 amendments that created more certainty for shopping center owners now provide an important ‘firewall’ which prevents the failure of one retailer from cascading to other businesses. Under the prior law, lingering uncertainty caused neighboring stores to suffer from reduced traffic and sales while potential new tenants were reluctant to rent space in a shopping center with an uncertain future. For property owners, the contraction in credit has been even more problematic; a bankrupt tenant can cause a shopping center to default on a mortgage with no ability to cure the default. Such defaults include covenants to maintain minimum occupancy and debt service coverage.”), available at Commission website, supra note 55. V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 140 of 402 Bankruptcy Institute provides to landlords.490 After considering and debating different approaches that ranged from reversion to the pre-BAPCPA standard to maintenance of the status quo, the Commission voted to provide the debtor in possession one year from the petition date to make its assumption, assignment, or rejection decision with respect to nonresidential real property leases. The Commission also discussed the split in the courts regarding the method — i.e., the billing approach or the accrual approach — that should be used to determine whether certain rent owed under the lease should be deemed a prepetition or a postpetition obligation. The Commission reviewed case law citing both approaches to determine which approach should be adopted and codified, and focused its efforts on creating, first and foremost, a uniform standard. Ultimately, the Commission decided that the accrual method, which allocates rent between the prepetition and postpetition periods based on the date of filing, was a fair method and most closely aligned with the purpose of section 365(d)(3). The Commission further considered the scope of a debtor in possession’s obligations under section  365(d)(3). Some of the Commissioners commented on the ambiguity in the case law regarding which obligations were captured by section 365(d)(3) and how those obligations, if deferred or unpaid, should be treated. With respect to which obligations should be deemed “rent,” the Commission reviewed the language of section 365(d)(3), which references section 365(b)(2), but not historical nonmonetary obligations in section 365(b)(1). The Commissioners debated whether 16 this omission in the statute suggests that a debtor in possession should ber required to perform all 1, 20 be 2 nonmonetary obligations on and after the petition date as providedvem section 365(d)(3). Several No in d on hiv section 365(d)(3) may be inconsistent cof e ar Commissioners, however, highlighted that such a reading 363 4-35 . 1and approaches. Specifically, these Commissioners with the Commission’s recommended policies , No rown v. B(i)  should not be required to perform under any executory asserted that a debtor in possession eth Blixs contracts or unexpired d in e leases, except to pay for postpetition goods and services (including rent), cit pending assumption or rejection; and (ii) should not be required to cure nonmonetary defaults that occurred prior to assumption. In light of these recommendations and the Commission’s proposal for a relatively modest extension of the section 365(d)(4) deadline, the Commission decided to recommend limiting section  365(d)(3) to monetary obligations under the leases and to provide ordinary administrative priority (not superpriority) to any such unpaid or deferred obligations under section 365(d)(3). In addition, the Commissioners evaluated the inconsistent application of section  502(b)(6) to calculate the maximum amount of a landlord’s rejection damages. The Commission agreed with courts that have held that whether a given obligation is labeled as “rent” under a lease should not determine whether such obligation is subject to the section  502(b)(6) cap. The Commissioners identified obligations that have been commonly considered as “rent” (e.g., monthly payments for occupying the property (including base rent, additional rent, percentage rent), common area 490 Id. at 2 (June 4, 2013) (stating that the time limits for debtors to assume or reject a nonresidential lease introduced by BAPCPA have “provid[ed] shopping center owners with reasonable certainty as to the disposition of leases, have prevented deterioration in shopping center properties and helped owners have access to credit to finance construction and renovation”), available at Commission website, supra note 55; Oral Testimony of the Honorable Melanie Cyganowski (Ret.), former U.S. Chief Bankruptcy Judge, E.D.N.Y.: CFA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 19 (Nov. 15, 2012) (CFA Transcript) (stating that it would be beneficial to the court and will encourage more secured lenders to support middle-market borrowers if the BAPCPA Amendments relating to lease and plan deadlines were repealed, or at a minimum amended to provide judicial discretion to be exercised to modify the deadlines as appropriate), available at Commission website, supra note 55.  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 141 of 402 ABI Commission to Study the Reform of Chapter  maintenance charges, taxes, and insurance) and determined that the definition of “rent” suggested by the advisory committee — “any recurring monetary obligations of the debtor under the lease” — adequately captured these obligations. The Commissioners also analyzed the varying interpretations and applications of the formula for calculating the cap on rejection damages under section 502(b)(6). The Commission agreed that many courts have confused or misapplied the formula and that, simply stated, the cap should be the rent reserved under the lease for the greater of (i) one year and (ii) the shorter of 15 percent of the remaining term and three years, plus unpaid rents. Accordingly, the Commission voted to recommend clarifying the calculation formula. Finally, the Commission considered the treatment of nontermination damages that a landlord may assert against the estate. These claims typically arise out of the debtor’s use or occupancy of the property and are not related to the debtor’s rejection of the lease. Notably, section 502(b)(6) applies to, and limits, “the claim of a lessor for damages resulting from the termination of a lease of real property.” Accordingly, the Commission agreed that a landlord should be able to file a prepetition claim against the estate, to the extent that the landlord can establish a legal basis and adequate factual support for such claim, for damages not resulting from the rejection of the lease. Such claim would be subject to the claims objection and allowance process under the Bankruptcy Code. 2 B. Use, Sale, or Lease of Property vofbethe016 r 21, Estate em No d on chive ar 5363 Section 363 of the Bankruptcy Code addresses3the debtor in possession’s use, sale, or lease of property . 14, No o during the chapter 11 case. Sectionwn v. Br 363(c) permits the debtor in possession to engage in certain of eth these transactionsed inthexs in Bli ordinary course of business without court approval.491 If the debtor in cit possession wants to use, sell, or lease property outside the ordinary course of business, section 363(b) requires, among other things, notice and a hearing, and prior court approval.492 Section 363(f), in turn, allows the debtor in possession to sell property free and clear of any interest in such property under certain circumstances.493 1. General Provisions for Non-Ordinary Course Transactions Recommended Principles: Except in the context of a sale of all or substantially all of a debtor’s assets (i.e., a section  363x sale), the court should approve the use, sale, or lease of a debtor’s assets outside the ordinary course of business only if the court finds by a preponderance of the evidence that the trustee exercised reasonable business judgment in connection with the proposed transaction. This approach often is 491 11 U.S.C. § 363(c)(1). Nevertheless, if a debtor is selling, leasing, or using assets that constitute “cash collateral,” then the debtor must obtain the secured creditor’s consent or court approval. Id. § 363(c)(2). 492 Id. § 363(b). 493 Id. § 363(f). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 142 of 402 Bankruptcy Institute referred to as an “enhanced” or “intermediate” level of review that considers not only the process adopted by the board of directors (or similar governing body) to approve the transaction but also the reasonableness of the decision itself. Only the trustee should be able to propose the use, sale, or lease of a debtor’s assets outside the ordinary course of business. Accordingly, no change to existing law is suggested on this point. A secured creditor’s collateral should not be subject to a mandatory surcharge in favor of the estate but the court should retain the authority to make appropriate allocations of value to the estate as may be warranted under the circumstances pursuant to sections 506(c) and 552(b) of the Bankruptcy Code, as clarified by the related principles. See Section VI.C.3, Section  506(c) and Charges Against Collateral; Section VI.C.4, Section 552(b) and Equities of the Case. For the standard of review governing section 363x sales, see Section VI.B, Approval of Section 363x Sales. General Provisions for Non-Ordinary Course Transactions: Background 2016 , In general, section 363(b) of the Bankruptcy Code provides that the debtor2in possession,494 “after er 1 emb v notice and a hearing, may use, sell, or lease, outside the ordinary n No of business, property of the d o course chive estate.”495 The debtor in possession can use, sell, or3lease ar single asset, multiple assets, a division, or 5363 a 14No. more. A sale of all or substantially all ofothe, debtor’s assets is addressed separately in these principles wn . Br eth v of review and additional procedures.496 and is subject to a different Blixs standard in cited Under section 363(b), a debtor in possession generally must provide at least 21 days’ notice of a motion to approve a proposed use, sale, or lease of property.497 In general, any party in interest may object to the motion. At the hearing, the debtor in possession bears the burden of proof on the motion and generally must satisfy that burden by a preponderance of the evidence.498 Courts generally evaluate section 363(b) motions under a business judgment standard. More precisely, courts often state they will approve the motion only if it represents an exercise of the debtor in possession’s sound business judgment.499 But, courts are not always clear or consistent in explaining the factors they consider under this business judgment standard. 494 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. 495 Id. § 363(b). 496 See Section VI.B, Approval of Section 363x Sales. 497 Fed. R. Bankr. P. 2002. 498 In re Lionel Corp., 722 F.2d 1063, 1071 (2d Cir. 1983) (“[A] debtor applying under § 363(b) carries the burden of demonstrating that a use, sale or lease out of the ordinary course of business will aid the debtor’s reorganization . . . .”); In re Telesphere Commc’ns, Inc., 179 B.R. 544, 552 (Bankr. N.D. Ill. 1994) (“[T]he proponent of the sale bears the ultimate burden of persuasion . . . .”); In re Ionosphere Clubs, Inc., 100 B.R. 670, 675 (Bankr. S.D.N.Y. 1989) (“[Debtor] clearly bears the burden of demonstrating that a sale of property out of the ordinary course of business under § 363(b) of the [Bankruptcy] Code will aid [debtor’s] reorganization and is supported by a good business justification.”). 499 In re On-Site Sourcing, Inc., 412 B.R. 817, 822 (Bankr. E.D. Va. 2009) (“‘A § 363(b) sale is generally viewed as quicker. Only a motion and a hearing are required, and most courts apply a ‘business judgment test’ to determine whether to approve the sale.’”) (quoting In re Gulf Coast Oil Corp., 404 B.R. 407, 415 (Bankr. S.D. Tex. 2009)).  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 143 of 402 ABI Commission to Study the Reform of Chapter  General Provisions for Non-Ordinary Course Transactions: Recommendations and Findings The Commissioners engaged in a detailed review of the various kinds of non-ordinary course transactions pursued by debtors in possession under section 363(b). Debtors in possession have used this provision to enter into long-term equipment lease arrangements or new real property leases that require a substantial outlay of resources; to hire a service provider who is not a professional under section 327; and even to compromise and settle a cause of action.500 The most common use of section 363(b), however, is to sell the debtor’s assets. In each of these instances, the estate is potentially losing something — i.e., cash in the lease, hiring, and settlement scenarios, and assets in the sale context. The Commissioners thus emphasized the important roles of process and review in the approval of these transactions. The Commissioners examined the various standards of review applicable to similar transactions under state law. In many cases, directors’ decisions are protected under state law by the business judgment rule, which presumes that “‘in making a business decision the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company.’”501 Courts have articulated slightly different standards for reviewing proposed transactions under either the business judgment rule or some enhanced form of scrutiny. These variations typically depend on the kind of transaction at issue and the parties involved in the 016 transaction. 21, 2 r mbe Nove on i For example, some courts undertake a very deferentialved arch review of a company’s business judgment, 363 focusing largely on the process followedNo.the-35 by 14 board of directors to evaluate and approve the proposed n, transaction; these courts then v. Brow the company’s articulated business justifications.502 This type defer to eth s of deferential judicial Blix in review often is explained by the notion that business decisions are better cited made in the boardroom than the courtroom.503 Other courts scrutinize proposed transactions more closely, reviewing not only the process implemented by the company, but also the reasonableness of the board of directors’ business judgment under the circumstances of the case.504 This latter review often is referred to as an “enhanced” or “intermediate” business judgment standard. In certain 500 In re Schipper, 933 F.2d 513, 515 (7th Cir. 1991) (holding that debtor had “sound business reasons for making the sale”); In re Cont’l Air Lines, Inc., 780 F.2d 1223, 1226 (5th Cir. 1986) (“[F]or the debtor-in-possession or trustee to satisfy its fiduciary duty to the debtor, creditors and equity holders, there must be some articulated business justification for using, selling, or leasing the property outside the ordinary course of business.”); In re Ionosphere Clubs, Inc., 100 B.R. 670, 680 (Bankr. S.D.N.Y. 1989) (finding that debtor “articulated sound business reasons for, and is appropriately exercising business judgment with respect to, its decision to sell [certain assets]”); In re Baldwin United Corp., 43 B.R. 888, 897 (Bankr. S.D. Ohio 1984) (finding that debtors “met their burden of demonstrating that the disposition will aid their reorganization, and is supported by sound business reasons”). 501 In re Walt Disney Co. Derivative Litig., 906 A.2d 27, 52 (Del. 2006) (quoting Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984)). 502 Paramount Commc’ns Inc. v. QVC Network Inc., 637 A.2d 34, 45 n.17 (Del. 1994); In re Walt Disney Co. Derivative Litig., 906 A.2d 27, 74 (Del. 2006) (quoting Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971)). 503 See, e.g., Brehm v. Eisner, 746 A.2d 244, 266 (Del. 2000) (holding that the Court of Chancery correctly deferred to the business decision of the board because “[t]o rule otherwise would invite courts to become super-directors, measuring matters of degree in business decisionmaking and executive compensation. Such a rule would run counter to the foundation of our jurisprudence”). See also King v. Terwilliger, 2013 WL 708495, at *7 (S.D. Tex. Feb. 26, 2013) (finding that compensation issues are business questions “far better suited to the boardroom than the courtroom”); In re Curlew Valley Assocs., 14 B.R. 506, 511 (Bankr. D. Utah 1981) (“[D]isagreements over business policy are not amenable to judicial resolution. The courtroom is not a boardroom. The judge is not a business consultant. While a court may pass upon the legal effect of a business decision, (for example, whether it violates the antitrust laws), this involves a process and the application of criteria fundamentally different from those which produce the decision in the first instance. In short, the decision calls for business not legal judgment.”). 504 In re Netsmart Techs., Inc. Stockholders Litig., 924 A.2d 171, 192 (Del. Ch. 2007). See also Paramount Commc’ns Inc. v. QVC Network Inc., 637 A.2d 34, 45 (Del. 1994) (“[C]ourt applying [the Revlon standard] should be deciding whether the directors made a reasonable decision, not a perfect decision. If a board selected one of several reasonable alternatives, a court should not second-guess that choice even though it might have decided otherwise or subsequent events may have cast doubt on the board’s determination.”). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 144 of 402 Bankruptcy Institute limited circumstances, courts apply heightened scrutiny under which the court exercises its own business judgment and determines if the decision is in the best interests of the company.505 Finally, if the proposed transaction involves potential self-dealing, conflicts of interests, or insiders, the court may require the company to establish the entire fairness of the transaction.506 After much deliberation, the Commission determined that an enhanced business judgment standard was appropriate for evaluating general asset sales and other transactions under section 363(b). The court should approve the sale if it represents a reasonable process and a reasonable exercise of the debtor in possession’s business judgment. Moreover, the Commission agreed that only the debtor in possession should be permitted to request the use, sale, or lease of property of the estate, which currently is the structure of section 363. The Commissioners discussed situations in which the debtor in possession sells assets, and unsecured creditors seek recoveries from that sale, despite the fact that such assets are fully encumbered by a secured creditor’s lien. The Commissioners recognized that this situation has occurred more frequently in the most recent economic cycle. Debtors have filed chapter 11 cases with substantially all of their assets fully encumbered by prepetition liens, leaving little value for the debtors’ other creditors, at least at the outset of the case. The Commissioners noted that, in some cases, secured lenders will agree to set aside certain amounts for administrative or unsecured claims. The Commissioners, however, did not believe that such surcharges should be mandatory in every section 363 transaction. 16 Rather, parties should remain free to negotiate these types of set-asides based2on the facts of any 1, 0 ber 2 em given case. In addition, the Commission reviewed the recommendedvprinciples relating to sections n No ed o rchiv 506(c)507 and 552(b),508 and found that those sections,3together with the new procedures proposed 6 a -353 o 14 for section 363x sales,509 sufficiently addressed. the underlying concerns. n, N cited h v. xset n Bli i Brow 505 See Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981) (indicating that judicial business judgment may be warranted in derivative litigation involving a special litigation committee in which demand was excused under applicable state law). See also, e.g., In re Telesphere Commc’ns, Inc., 179 B.R. 544, 552 (Bankr. N.D. Ill. 1994) (“Where an objection is made, the standard to be applied by the court in approving a disposition of assets is variously stated, but the general thrust is that the proposed sale should be in the best interests of the estate.”); In re Am. Dev. Corp., 95 B.R. 735, 739 (Bankr. C.D. Cal. 1989) (“The proposed transaction is certainly not in the ordinary course of business and requires [the court’s] approval. Debtor has the burden of proof to persuade [the court] that the proposed transaction is appropriate in light of its reorganization effort and should be approved.”). Also, some courts have been less deferential with respect to break-up fees. See, e.g., In re Tiara Motorcoach Corp., 212 B.R. 133, 137 (Bankr. N.D. Ind. 1997) (“This court agrees with the position taken in S.N.A., America West, and Hupp. A sale pursuant to § 363 of the Bankruptcy Code is outside the ordinary course of business, and the business judgment of the debtor should not be solely relied upon. Rather, a court should insure that revenues are maximized and that the best interests of the debtor’s estate, creditors and equity holders are furthered. Therefore, ‘the proposed break-up fee must be carefully scrutinized to insure that the Debtor’s estate is not unduly burdened and that the relative rights of the parties in interest are protected.’”) (citations omitted); In re Am. W. Airlines, Inc., 166 B.R. 908, 912 (Bankr. D. Ariz. 1994) (“[T]he Court must take into consideration what is in the best interests of the estate. As stated, the standard is not whether a break-up fee is within the business judgment of the debtor, but whether the transaction will ‘further the diverse interests of the debtor, creditors and equity holders, alike.’”) (citing In re Lionel Corp., 722 F.2d 1063, 1071 (2d Cir. 1983)). But see Official Comm. of Subordinated Bondholders v. Integrated Res. (In re Integrated Res., Inc.), 147 B.R. 650 (S.D.N.Y. 1992), appeal dismissed by 3 F.3d 49 (2d Cir. 1993) (finding that the business judgment rule applied in nonbankruptcy contexts and thus relied upon that standard in the bankruptcy context as well to determine whether the proposed breakup fee at issue was appropriate). 506 Telxon Corp. v. Meyerson, 802 A.2d 257, 264 (Del. 2002). See also Paramount Commc’ns Inc. v. QVC Network Inc., 637 A.2d 34, 42 n.9 (Del. 1994) (“Where actual self-interest is present and affects a majority of the directors approving a transaction, a court will apply even more exacting scrutiny to determine whether the transaction is entirely fair to the stockholders”). 507 See Section VI.C.3, Section 506(c) and Charges Against Collateral. 508 See Section VI.C.4, Section 552(b) and Equities in the Case. 509 See Section VI.B, Approval of Section 363x Sales.  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 145 of 402 ABI Commission to Study the Reform of Chapter  2. Finality of Orders Recommended Principles: The court should not be permitted to reconsider a non-ordinary course transaction after the entry of an order approving the transaction or to reopen an auction unless the court finds extraordinary circumstances or material procedural impediments (such as the lack of adequate notice or an improperly conducted sale process) to the auction process that may have had a material effect on the sale results. For purposes of this principle, the potential that a new or continued auction would generate a higher value for the transaction alone does not constitute extraordinary circumstances. Finality of Orders: Background In the section 363 sale context, a debtor in possession510 seeks to obtain the highest and best price for the assets. As explained above, a debtor in possession typically conducts an auction process to facilitate this result.511 The auction procedures are reviewed and approved by the court and may include a marketing and diligence period and rules governing the auction itself.512 The auction 16 procedures also may contemplate certain bid protections for any stalking, horse bidder.513 After the 1 20 ber 2 m auction, the debtor in possession presents the winning bidoat Noveauction to the court for approval n the ed hv under the motion to approve the sale. After the6court ienters the sale order, parties generally have 3 arc -353 14 days to appeal the order or it becomes. 14 514 Generally, courts are not permitted to reopen an , No final. own 515 v. Br auction or sale. h ixset in Bl cited 510 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. 511 See Section IV.C.2, Timing of Section 363x Sales. 512 One court concluded that “it was necessary to have in place bidding procedures that would provide a reasonable opportunity for the APA to be tested against the market.” In re Tex. Rangers Baseball Partners, 431 B.R. 706, 711 (Bankr. N.D. Tex. 2010). See also In re Innkeepers USA Trust, 448 B.R. 131, 148 (Bankr. S.D.N.Y. 2011) (explaining that bid procedures provide “the market and the Debtors the certainty and the ‘rules’ that they need to complete the auction process and move on to plan confirmation”). 513 A leading bankruptcy treatise explains the rationale for deciding such bid protections in advance of the auction: Frequently, the issue of whether the court should approve buyer protections arises upon a motion to approve bidding procedures. The court is asked to approve, before the fact, procedures the propriety of which may be better determined after the “auction” of the property. For example, the reasonableness of a breakup or topping fee may be more difficult to evaluate in a vacuum before the sale. Whether a particular procedure chilled bidding may not be determinable until after the trustee offers the successful bid to the court for approval. However, the fees are to compensate the bidders for facilitating the auction, for example, by guaranteeing a floor on the bidding. If the court were not to approve the fee until after the auction, the leading bidder would not have the assurance necessary to commit to support the auction. Therefore, authorizing the fee only after the auction would defeat its purpose, and the court should address the issues upon a motion to approve the bid procedures.” 3 Collier on Bankruptcy ¶ 363.02[7]. 514 Bankruptcy Rule 6004(h) provides that “[a]n order authorizing the use, sale, or lease of property other than cash collateral is stayed until the expiration of 14 days after entry of the order, unless the court orders otherwise.” Fed. R. Bankr. P. 6004(h). 515 See Contrarian Funds, LLC v. Westpoint Stevens, Inc. (In re Westpoint Stevens, Inc.), 333 B.R. 30 (S.D.N.Y. 2005), aff ’d in part and rev’d in part sub nom. Contrarian Funds v. Aretex LLC (In re WestPoint Stevens, Inc.), 600 F.3d 231 (2d Cir. 2010). See also In re Gil-Bern Indus., Inc., 526 F.2d 627, 628, 629 (1st Cir. 1975) (“[I]t is an abuse of discretion for a bankruptcy court to refuse to confirm an adequate bid received in a fairly conducted sale merely because a slightly higher offer has been received after the bidding has closed.”); In re Bigler, LP, 443 B.R. 101, 112 (Bankr. S.D. Tex. 2010) (“To reopen the bidding process to allow [a losing bidder] to make its late bid would be an abuse of this Court’s discretion. Accordingly, this Court will not reopen bidding.”). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 146 of 402 Bankruptcy Institute Several issues can arise during the course of the sale process, including modifications to the auction procedures without notice to or approval by the court, bidders wanting to submit noncompliant bids, and even late bidders who cause the debtor in possession, the unsecured creditors’ committee, or other party in interest to question whether the bid selected at the auction really is the best and highest offer for the debtor’s assets. In this context, courts have granted motions to reopen an auction if it would likely result in a better offer.516 Accordingly, courts face challenging issues and competing interests when confronted with requests to reopen the auction process or to reconsider the order approving the sale under section 363 of the Bankruptcy Code. Finality of Orders: Recommendations and Findings The closing of an auction and the entry of a sale order are key steps in the sale of the debtor’s assets. They allow the debtor in possession to close the sale and move forward in the case and the successful bidder to take possession of the assets. The Commissioners discussed the importance of the value generated by section 363 sales to the estate, and the common desire to want to ensure that the sale process is extracting as much value as possible from the assets. The Commission reviewed examples in which this desire caused the debtor in possession, the unsecured creditors’ committee, or a party in interest to second-guess the auction results or the sale order and to seek related relief from the court. 016 ,2 For example, in the WestPoint Stevens517 chapter 11 case, the debtor in possession obtained approval er 21 emb of the court to conduct an auction for substantially all of the d on Nov assets.518 One of the debtor’s debtor’s ive arch secured creditors, Aretex LLC, along with its affiliates, emerged as the winning bidder at the 5363 14-3 519 No. auction. The court approved the salerand,entered a sale order permitting the consummation of the n B ow e best sale to Aretex for the highest landth v. bid.520 But, before the sale closed, certain other lenders moved xs nBi ted i for a stay of the saleciorder pending appeal of certain provisions in the sale order related to lien releases, claim satisfaction, and distributions.521 On appeal, however, the Second Circuit rejected the appeal as statutorily moot under section 363(m).522 The Commission also reviewed a contrary example found in the Foamex chapter 11 case. In that case, the debtors had selected an all-cash bid that was $5 million lower than the all-cash bid of the stalking horse because the stalking horse had conditioned its bid on the inclusion of a credit bid if the auction continued past the then-present round. The bankruptcy reopened the auction and directed the debtors in possession to accept the stalking horse bid (which included the credit bid), even though the debtors in possession had complied with the court-approved bid procedures in 516 In re Foamex Int’l, Inc., No. 09-10560 (KJC) (Bankr. D. Del. May 27, 2009). See also Lithograph Legends, LLC v. U.S. Trustee, 2009 WL 1209469, at *3 (D. Minn. Apr. 30, 2009) (“A bankruptcy court may disapprove a proposed sale recommended by a debtor-in-possession ‘if it has an awareness there is another proposal in hand which, from the estate’s point of view, is better or more acceptable.’”) (quoting G-K Dev. Co v. Broadmoor Place Invs., L.P. (In re Broadmoor Place Invs., L.P.), 994 F.2d 744, 746 (10th Cir. 1993)). 517 Contrarian Funds, LLC v. Westpoint Stevens, Inc. (In re Westpoint Stevens, Inc.), 333 B.R. 30 (S.D.N.Y. 2005), aff ’d in part and rev’d in part sub nom. Contrarian Funds v. Aretex LLC (In re WestPoint Stevens, Inc.), 600 F.3d 231 (2d Cir. 2010). 518 Id. at 35. 519 Id. at 36. 520 Contrarian Funds LLC v. Aretex LLC (In re WestPoint Stevens, Inc.), 600 F.3d 231, 242 (2d Cir. 2010) (noting that bankruptcy court entered order confirming that “the winning bid presented ‘the highest and best bid at the Auction’”) (citations omitted). 521 Contrarian Funds, LLC v. Westpoint Stevens, Inc. (In re Westpoint Stevens, Inc.), 333 B.R. 30, 37 (S.D.N.Y. 2005), aff ’d in part and rev’d in part sub nom. Contrarian Funds v. Aretex LLC (In re WestPoint Stevens, Inc.), 600 F.3d 231 (2d Cir. 2010). 522 Contrarian Funds v. Aretex LLC (In re WestPoint Stevens, Inc.), 600 F.3d 231, 247 (2d Cir. 2010).  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 147 of 402 ABI Commission to Study the Reform of Chapter  accepting the previous bid. The court thereafter overruled the objection by the previous winning bidder to the sale. The Commissioners acknowledged that, in some cases, reopening the auction or reconsidering the sale order may generate additional value for the estate. They also raised concerns, however, that endorsing this type of relief may prevent robust auctions in the first instance because prospective bidders need to understand the rules of the auction and to know that, if they participate according to the rules and win, they will be able to close the sale. This type of certainty and respect for the auction rules and sale order can enhance the auction itself and prevent gamesmanship by prospective bidders. The Commissioners also noted that courts currently have the ability to reconsider their orders under Rule 60(b) of the Federal Rules of Civil Procedure, which provides that the court may relieve a party from a final order if presented with “newly discovered evidence which by due diligence could not have been discovered in time to move for a new trial” and due to “fraud . . . misrepresentation, or other misconduct of an adverse party.” The Commissioners reviewed cases in which courts have reconsidered (or refused to reconsider) sale orders. 523 They acknowledged that a motion to reconsider a section 363 sale order can be clouded by the prospect of more value for the estate. Nevertheless, the Commissioners believed that more value alone as ground for reopening an auction or setting aside a sale order was too low of a barrier, did not comply with Rule 60(b), and would introduce too much uncertainty into the sale process. 16 1, 20 ber 2 Consequently, the Commission voted to recommend codifyingovemstandards governing requests to N the d on chive reopen an auction or to reconsider and set aside 3 asale order. Specifically, it determined that such a r 3536 . 4relief should be warranted only in instances1when the evidence presented at the hearing demonstrates No wn, procedural impediments in th v. auction or sale process or extraordinary circumstances. the Bro e Blixs ed in cit 3. Transactions Free and Clear of Interests Recommended Principles: In general, the trustee should be able to sell a debtor’s assets free and clear of all interests in a debtor’s assets, including liens and encumbrances, to the extent permitted by the U.S. Constitution and the guidelines set forth in these principles. In addition, the trustee should be able to sell a debtor’s assets free and clear of all claims related to a debtor’s assets in the context of a sale of all or substantially all of a debtor’s assets under section 363x (or a transaction involving less than substantially all of the debtor’s assets if the court determines that the trustee has otherwise complied with the requirements of section 363x). A trustee should be able to sell assets free and clear of interests if applicable nonbankruptcy law would permit the owner of such assets to sell them free and clear of such interests. The foreclosure rights of a creditor or other third party 523 For examples of courts considering the finality issue and refusing to reopen auction, see In re Bigler, LP, 443 B.R. 101 (Bankr. S.D. Tex. 2010); In re Extended Stay Inc., No. 09-13764 (JMP) (Bankr. S.D.N.Y. June 17, 2010) [Docket No. 1102] (transcript of record); In re Finlay Enters., Inc., No. 09-14873 (Bankr. S.D.N.Y. Nov. 12, 2009) [Docket No. 378] (transcript of record). But see Corporated Assets, Inc. v. Paloian, 368 F.3d 761 (7th Cir. 2004) (auction reopened due to improper procedures). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 148 of 402 Bankruptcy Institute should not be determinative in this context. Bankruptcy Code section 363(f)(1) and (5) should be amended accordingly. A trustee should be able to sell assets free and clear of interests without the consent of any lienholder and regardless of whether the assets generate value in excess of the aggregate value of the liens in the assets, provided that the liens attach to the proceeds of the sale or the lienholder receives another appropriate form of adequate protection of the lien. Section 363(f)(3) should be amended accordingly. In the context of a section 363x sale, a trustee should be able to sell assets free and clear of any successor liability claims (including tort claims) other than those specifically excluded from free and clear sales by these principles. The court should not approve a sale of a debtor’s assets free and clear of the following kinds of interests: (i) easements, covenants, use restrictions, usufructs, or equitable servitudes that are deemed to “run with the land” under applicable nonbankruptcy law; (ii) environmental obligations that are deemed to “run with the land” under applicable nonbankruptcy law; (iii)  successorship liability for purposes of federal labor law; and (iv) partial, competing, or disputed ownership interests, except to the extent specified in section 363(h) or (i). 6 , 201 r 1 The sale of a debtor’s assets free and clear of executory contracts2and unexpired mbe Nove on leases should be governed by section 365 or, for collective bargaining agreements, ived arch section 1113. Accordingly, the trustee should3be permitted to sell the debtor’s assets 536 14-3 No. and unexpired leases only to the extent such free and clear of executoryBrown, contracts v. ethrejected in accordance with section 365 or section 1113, as contracts and leasesxare i s in Bl ited cand the trustee is permitted by section 365 to recover the property free applicable, and clear of the nondebtor counterparty’s rights to use or possess such property. The court’s approval of a sale free and clear of interests or claims under section 363(f) should continue to be considered part of the court’s approval of the overall transaction under section 363(b) or (c). Accordingly, no change to existing law is suggested on this point. To the extent permitted by these principles for other claims, the trustee should be able to sell a debtor’s assets free and clear of any monetary claims by the federal government or a state government against the debtor or the estate, provided that such monetary claims constitute “claims” under section 101(5) under current law. The trustee should not be able to sell a debtor’s assets free and clear of any enforcement rights of such government to the extent that such rights are within such government’s police or regulatory powers and could be enforced against the debtor or the estate under section 362(b)(4), or to the extent that the state or federal government incurs costs post-sale in the exercise of its police or regulatory powers.  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 149 of 402 ABI Commission to Study the Reform of Chapter  Transactions Free and Clear of Interests: Background In many chapter 11 cases, some or all of the debtor’s property is encumbered or subject to the liens, interests, and claims of various stakeholders. The holders of these liens, interests, and claims may have rights under nonbankruptcy law or prepetition agreements that make the transfer of the debtor’s assets difficult or less attractive to prospective lessees and purchasers. These liens, interests, and claims may include mortgages, security interests, easements, or successor liability claims. Under section 363(f), a debtor in possession524 may sell its assets under section 363(b) or (c) “free and clear of any interest in such property of an entity other than the estate” only if: (1) ”applicable nonbankruptcy law permits sale of such property free and clear of such interest”; (2) “such entity consents”; (3) “such interest is a lien and the price at which such property is to be sold is greater than the aggregate value of all liens on such property”; (4) “such interest is in bona fide dispute”; or (5) “such entity could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest.”525 Section 363(f) is limited to “any interest in such property.” Notably, this language is different from that used in section 1141(c), which speaks to “property dealt with by the plan [being] free and clear of all claims and interests of creditors, equity security holders, and of general partners in the debtor.”526 The legislative history of section 363(f) provides little guidance on the scope of the term “interest,” other than to acknowledge that a lien should be considered an interest016 property.527 Courts , 2 in er 21 bfirst construes section  363(f) em interpreting this section have taken two general approaches:ovthe nN ed o mortgages, and money judgments;528 narrowly and limits its application to liens, security rinterests, chiv 63 a -353interests and captures claims against the debtor or and the second takes a more expansive o. 14 of view ,N rown estate property, including successor liability claims, discrimination claims, personal injury claims, v. B seth and other “claims” d in Blix the meaning of section 101(5) of the Bankruptcy Code.529 Some courts within cite and commentators argue that the expansive approach is necessary to facilitate sales under section 363(f) and to achieve the underlying policy objectives of the Bankruptcy Code.530 524 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. 525 11 U.S.C. § 363(f). 526 Id. § 1141(c). 527 The legislative history provides, in relevant part: At a sale free and clear of other interests, any holder of any interest in the property being sold will be permitted to bid. If that holder is the high bidder, he will be permitted to offset the value of his interest against the purchase price of the property. Thus, in the most common situation, a holder of a lien on property being sold may bid at the sale, and if successful, may offset the amount owed to him that is secured by the lien on the property (but may not offset other amounts owed to him) against the purchase price, and be liable to the trustee for the balance of the sale price, if any. H.R. Rep. 95-595 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6302; S. Rep. 95-989 (1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5842. 528 See, e.g., In re White Motor Credit Corp., 75 B.R. 944, 948 (Bankr. N.D. 1987); In re New England Fish Co., 19 B.R. 323, 329 (Bankr. W.D. Wash. 1982). 529 See, e.g., In re Trans World Airlines, Inc., 322 F.3d 283, 289 (3d Cir. 2003) (“[T]he trend seems to be toward a more expansive reading of ‘interests in property’ which ‘encompasses other obligations that may flow from ownership of the property’”) (citing 3 Collier on Bankruptcy ¶ 363.06[1]); In re WBQ P’ship, 189 B.R. 97, 105, (Bankr. E.D. Va. 1995). 530 See, e.g., In re Trans World Airlines, Inc., 322 F.3d 282, 290 (3d Cir. 2003) (suggesting a trend toward an expansive view of section 363(f) to include claims); Folger Adam Sec., Inc. v. DeMatteis/MacGregor, JV, 209 F.3d 252 (3d Cir. 2000) (holding that pursuant to section 363(f), the debtors’ contractual payment rights was free and clear of a contractor’s previously unexercised setoff rights, but was not free and clear of the contractor’s recoupment rights because by their very nature, recoupment rights simply cannot be considered an “interest” in property extinguished by a section 363(f) free-and-clear sale”); In re Tougher Indus., Inc., 2013 WL 1276501, at *6 (Bankr. N.D.N.Y. Mar. 27, 2013). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 150 of 402 Bankruptcy Institute Courts also take different approaches to whether a debtor in possession has satisfied one of the grounds set forth in section 363(f) to support a sale free and clear of interests in the property.531 For example, some courts require the sale price to exceed the face value of secured claims asserted against the property to satisfy section 363(f)(3).532 Other courts require only that the sale price exceed the economic value of the creditors’ allowed secured claims under section  506.533 Courts also disagree as to what constitutes a bona fide dispute for purposes of section 363(f)(4).534 They also have taken different approaches to whether the language in section 363(f)(5) providing that the “entity could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest” includes a cramdown of a chapter 11 plan under section 1129(b).535 Transactions Free and Clear of Interests: Recommendations and Findings The Commissioners analyzed section 363(f) of the Bankruptcy Code and the concept of sales “free and clear” of liens, interests, and claims. They reviewed the original focus of that section on “interests” in estate assets, and they discussed the expansion of that concept to claims of various kinds. The Commissioners identified different kinds of claims that courts have included within section 363(f), including litigation claims, discrimination claims, and successor liability claims. The Commission agreed that this expansive approach to section 363(f) fostered more competition for the debtors’ assets and likely enhanced the value of the assets sold through the section 363(f) sale process. The Commissioners questioned whether the historical nexus between “free and clear” sales 2016 under section 363(f) and in rem notions of property interests still servedber 21, bankruptcy policy. m ve n No ed o hiv To analyze this question, the Commission considered 3 arclanguage and purpose of section 1141(c) 6 the -353 . 14 of the Bankruptcy Code and the inclusionnof claims in the discharge injunction in connection with a , No row B h v. chapter 11 plan. The Commissioners suggested that this difference may relate to the more significant xset n Bli i ci provided to creditors in the plan process. Although creditors holding general notice and due processted unsecured claims (including the kinds of litigation and other claims mentioned above) do not have any particular interest in the debtor’s property, they receive notice and an opportunity to object to the treatment of their claims under the plan. In the section 363 context, such creditors may or may not receive notice of the sale motion or an opportunity to object. 531 See generally George W. Kuney, Misinterpreting Bankruptcy Code Section 363(f) and Undermining the Chapter 11 Process, 76 Am. Bankr. L.J. 235, 244 (2002). 532 See, e.g., Clear Channel Outdoor, Inc. v. Knupfer (In re PW, LLC), 391 B.R. 25, 40–41 (B.A.P. 9th Cir. 2008). See also Criimi Mae Servs., Ltd. P’ship v. WDH Howell, LLC (In re WDH Howell, LLC), 298 B.R. 527, 534 (D.N.J. 2003). See also Robert M. Lawless, BAP Prohibits Sale Free and Clear of an Underwater Junior Lien, Bankr. L. Letter, Oct. 2008, at 7 (“Although the result in Clear Channel will be controversial, its specific holding on section 363(f)(3) should not be. Its reasoning is compelling on the statutory language, and it reaches a result well within the mainstream of other court decisions. To sell free and clear under section 363(f) (3), the sales price must exceed the total value of all liens regardless of whether those are totally secured or undersecured.”) (citations omitted). 533 See, e.g., WBQ P’ship v. Va. Dep’t of Med. Assistance Servs. (In re WBQ P’ship), 189 B.R. 97, 105–06 (Bankr. E.D. Va. 1995); In re Beker Indus. Corp., 63 B.R. 474, 475–76 (Bankr. S.D.N.Y. 1986). 534 See, e.g., Union Planters Bank v. Burns (In re Gaylord Grain LLC), 306 B.R. 624 (B.A.P. 8th Cir. 2004). 535 See, e.g., Clear Channel Outdoor, Inc. v. Knupfer (In re PW, LLC), 391 B.R. 25, 46 (B.A.P. 9th Cir. 2008). See also Lawless, BAP Prohibits Sale Free and Clear of an Underwater Junior Lien, supra note 532, at 8 (“Instead of the Chapter 11 cramdown, a state foreclosure proceeding would seem to be a proceeding where the second lienholder could be compelled to accept a monetary satisfaction of its lien and thus satisfy the requirements of (f)(5). Indeed, the word ‘foreclosure’ means exactly that — the foreclosure of junior interests. A hypothetical state foreclosure proceeding seems so obvious that one wonders why the BAP [in Clear Channel] did not simply take judicial notice of it to hold that (f)(5) was satisfied. Perhaps the court’s concern was the lack of a solid record on how the foreclosure sale process would play out and specifically what value the property would bring at a foreclosure sale, although the bidding at the bankruptcy court would again seem to be an obvious place to look for the value of the property. The concern about the lack of a record perhaps can be seen in the BAP’s references to 363 sales being used to bypass the more procedurally robust confirmation requirements of section 1129 that could protect third-party rights.”) (citations omitted).  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 151 of 402 ABI Commission to Study the Reform of Chapter  The Commissioners evaluated whether this difference in process should preclude an expansive reading of section 363(f) that would include liens, interests, and claims. With respect to singleasset sales or smaller transactions, the Commission agreed that the notice currently required by the Bankruptcy Rules was likely sufficient, as assets remained in the estate to potentially fund claims through a chapter 11 plan. In a sale of all or substantially all of a debtor’s assets, however, the calculus may be different. On that point, the Commissioners noted that these principles recommend notice and due process procedures similar to what creditors are entitled to in the plan context. Accordingly, under the principles applicable to section 363x sales, creditors holding the kinds of claims subject to section 363(f) under the expansive view would receive notice and an opportunity to object to the proposed sale. The Commissioners were also persuaded that permitting the debtor in possession to transfer clean title to a purchaser under section 363(f) held potentially significant value for the estate. To that end, the Commissioners analyzed the conflicting interpretations of certain subsections of section 363(f) and identified approaches that would foster a competitive sale process while still protecting creditors’ rights against the estate. The Commission agreed that the scope of section 363(f)(1) and (5) should be clarified to focus on the property owner’s rights under applicable nonbankruptcy law.  The Commission also determined, however, that these ambiguities and perceived barriers to free and clear transfers in a chapter 11 case would likely be mitigated by its recommended change to section 363(f)(3). With the additional notice and process being recommended in the context of sales of all 16 1, 2 or substantially all of the debtor’s assets, the Commission determined 2that0adopting an expansive ber m N the view of section 363(f) was warranted and adequately protected ove interests of stakeholders. d on ive arch 363 -35 The Commissioners further considered o. 14 n, N whether any particular liens, interests, or claims should be Brow excluded from section 363(f) under this expansive approach. They methodically evaluated different th v. lixse in B kinds of claims and interests. They decided that the debtor in possession should be able to transfer cited property free and clear of all liens, interests, and claims, including without limitation: civil rights liabilities; successor liability in tort; and successor liability in contract. The Commissioners also concluded that the debtor in possession should not be able to transfer property free and clear of the following: easements, covenants, use restrictions, usufructs, or equitable servitudes that run with the land; environmental liabilities and related social policies that run with the land; successorship liability under federal labor laws; and partial, competing or disputed ownership interests, except to the extent specified in section 363(h) or (i). Moreover, the Commissioners recognized that a debtor in possession should not be able to sell or transfer assets under section 363(f) in a manner that violates or impedes the police or regulatory power of the federal government or a state government to the extent that such government could enforce those rights against the debtor in possession or estate property during the case, notwithstanding section 362(a) of the Bankruptcy Code. The Commission thus recommended that section 363(f) recognize the government’s police and regulatory powers to the extent such powers would be enforceable under section 362(b)(4). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 152 of 402 Bankruptcy Institute 4. Credit Bidding Recommended Principles: In a sale under section 363 of the Bankruptcy Code involving a secured creditor’s collateral, the secured creditor should be permitted to credit bid up to the amount of its allowed claim relating to such collateral unless the court orders otherwise for cause. For purposes of this principle, the potential chilling effect of a credit bid alone should not constitute cause, but the court should attempt to mitigate any such chilling effect in approving the process. Section 363(k) should be clarified accordingly. Credit Bidding: Background A creditor with a perfected lien in the debtor’s property has certain rights and remedies against the debtor and property within the creditor’s collateral package. Among other things, the secured creditor can credit bid the amount of its allowed claim in any sale of its collateral. A secured creditor’s right to credit bid exists under both state law and section 363(k) of the Bankruptcy Code. Section 363(k) provides: “At a sale under subsection (b) of this section of property that is subject to a lien 16 that secures an allowed claim, unless the court for cause orders otherwiseethe ,holder of such claim 1 20 b r2 m may bid at such sale, and, if the holder of such claim purchases d on Nove such property, such holder may offset e v ar such claim against the purchase price of such property.”536chi 363 -35 o. 14 n, N w A credit bid allows the secured eth v. Bro to purchase the property constituting its collateral if other creditor lixs in B bidders are not willingitto pay sufficient value or the creditor prefers to possess the collateral in lieu of c ed payment. The secured creditor also does not need to pay any cash for the property at the sale to the extent the allowed amount of its claim is sufficient to cover the price of its winning bid. Rather, the secured creditor can set off its secured claim against the debtor or the property against the purchase price it otherwise would be required to pay the estate.537 Although credit bidding is an integral part of the secured creditors’ rights package, it is not without limit. Specifically, section 363(k) allows the court to limit a secured creditor’s credit bid for cause.538 Courts typically have found cause to limit a credit bid if the amount of the secured creditor’s claim is disputed or unliquidated.539 Courts also have found cause to limit a credit bid, however, based on the conduct of the secured creditor. For example, In re Free Lance-Star Publishing Co., the court held that the secured creditor did not have the right to credit bid on assets that did not secure its allowed claim and found cause to limit the creditor’s right to credit bid at the auction based on, among other things, the creditor’s “overly zealous loan-to-own strategy,” in which the creditor acquired the loan 536 11 U.S.C. § 363(k). 537 Written Statement of Danielle Spinelli, Partner, WilmerHale, TMA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (Nov. 3, 2012) (providing historical overview and describing the evolution of credit bidding in bankruptcy), available at Commission website, supra note 55. 538 11 U.S.C. § 363(k) (“At a sale under subsection (b) of this section of property that is subject to a lien that secures an allowed claim, unless the court for cause orders otherwise the holder of such claim may bid at such sale, and, if the holder of such claim purchases such property, such holder may offset such claim against the purchase price of such property.”). 539 See, e.g., In re RML Dev., Inc., 2014 WL 3378578 (Bankr. W.D. Tenn. July 10, 2014) (valid claims objection that could not be resolved without delaying auction was cause to limit amount of credit bid).  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 153 of 402 ABI Commission to Study the Reform of Chapter  for the sole purpose of obtaining the right to credit bid at an expedited sale of the debtor’s assets and discouraged any competitive bidding.540 Similarly, in Fisker Automotive Holdings, the court found cause to limit the secured creditor’s ability to credit bid the entire amount of its secured claim because the amount was uncertain, and allowing the creditor to credit bid its entire claim would freeze out all competitive bidding by attractive and capable bidders.541 Credit Bidding: Recommendations and Findings The Commission considered credit bidding under section 363(k) in light of recent case law developments and an arguably expanded application of the cause standard for limiting credit bids. The Commissioners discussed the fundamental role of credit bidding under state law and section 363(k).542 They also acknowledged that all credit bidding chills an auction process to some extent. Accordingly, the Commissioners did not believe that the chilling effect of credit bids alone should suffice as cause under section 363(k). The Commissioners noted that, in some cases, it may be difficult to discern any chilling effect caused by the credit bid itself from a chilling effect resulting from the conduct of the secured creditor seeking to exercise its right to credit bid. For example, the Commissioners discussed situations in which the secured creditor demands a relatively short period to market the property and conduct the sale, requires the marketing materials to highlight the secured creditor’s right to credit bid, or 016 takes other actions to discourage a competitive bidding process. The er 21, 2 b Commission agreed that such em conduct could, in fact, depress the value of the property on Nopreclude the estate from receiving and v ed hiv 3 arc any return from the sale.543 The Commissioners,6however, did not want to endorse a principle that -353 14 would suggest that the chilling effect n, Nocredit bid warrants restrictions on the right to credit bid.544 of a . row v. B The Commission ultimatelyhagreed to maintain the current standard under section  363(k), with xset n Bli i cited the recommendation that the chilling effect of a credit bid not be deemed sufficient cause to limit a credit bid, but that courts should attempt to mitigate any chilling effect through the auction and sale procedures approved in the case. 540 In re Free Lance-Star Publ’g Co. of Fredericksburg, Va., 512 B.R. 798 (Bankr. E.D. Va. 20141), appeal denied, 512 B.R. 808 (E.D. Va. 2014). 541 In re Fisker Auto. Holdings, Inc., 510 B.R. 55 (Bankr. D. Del. 2014), appeal denied, 2014 WL 576370 (D. Del. Feb. 12, 2014). 542 See, e.g., Brubaker, The Post-RadLAX Ghosts of Pacific Lumber and Philly News, supra note 43, at 3 (“For secured creditors, operating on the assumption that in a free-and-clear sale of its collateral the sale price itself establishes the value of the collateral, credit bidding serves two protective functions — both as an undervaluation protection and a proceeds protection. Not only can the undersecured creditor bid in its claim to acquire the assets when it believes the otherwise prevailing sale price is too low, the undersecured creditor can also bid in its claim to acquire the assets when it believes that the proposed plan would not return to the undersecured creditor the full value of the proceeds generated by sale (i.e., the value) of its collateral.”); Ralph Brubaker, Credit Bidding and the Secured Creditor’s Baseline Distributional Entitlement in Chapter 11, Bankr. L. Letter, July 2012, at 8 (“[T]the legislative record indicates that the Code drafters also considered the credit bidding rights separately codified in § 363(k) to be an integral component of adequately protecting the secured creditor’s lien rights.”). “By holding that a dissenting secured creditor must be afforded credit-bidding rights under § 363(k) in any free-and-clear sale of its collateral under a plan of reorganization, RadLAX ensures that secured creditors have the same credit-bidding rights in plan sales that they have in § 363 sales.” Id. 543 See, e.g., Brubaker, The Post-RadLAX Ghosts of Pacific Lumber and Philly News, supra note 43, at 4 (“When the undersecured creditor’s collateral is the entirety of the debtor’s assets, therefore, credit-bidding rights in any going-concern sale of the debtor’s business and assets give that senior secured creditor the leverage to always insist upon capturing all of the debtor’s reorganization surplus, to the detriment of unsecured creditors and other junior classes.”). 544 Written Statement of Danielle Spinelli, Partner, WilmerHale, TMA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (Nov. 3, 2012) (“To the extent that the argument here is that cash bidders will be chilled because they fear that a secured creditor may outbid them, it lacks force. That would be equally true of any deep-pocketed bidder, and no auction can afford to exclude the bidders with the greatest resources on the ground that they might outbid everyone else.”), available at Commission website, supra note 55. V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 154 of 402 Bankruptcy Institute C. Avoiding Powers 1. Preference Claims Recommended Principles: The trustee’s ability to pursue preference claims under section 547 of the Bankruptcy Code preserves value for the estate and tempers the “run on the debtor” that may occur immediately prior to a bankruptcy filing. The avoiding power in section 547 may, however, be subject to abuse in certain cases. The Commission analyzed a variety of potential reforms to section 547, including refining elements of, or shifting the burden of proof for, certain defenses under section 547(c). After much research and deliberation, the Commission determined that the potential abuses under section 547 are addressed most effectively through the changes in small preference actions, pleading requirements, and demand requirements described in these principles, and continued judicial oversight in accordance with the Bankruptcy Code. The trustee should be precluded from issuing a demand letter to, or filing a 16 1 20 complaint against, any party for an alleged claim under section 547 ,unless, based ber 2 vem on reasonable due diligence, the trustee believesved ogood faith that a plausible in n No hi 3 c claim for relief exists against such party-underar 3536 section 547, taking into account the . 14 party’s known or reasonablyrown, No affirmative defenses under section 547(c). knowable B h v. xset n Bli i The trustee imust plead with particularity factual allegations in the complaint that c ted establish a plausible claim for relief under section  547. In accordance with the U.S. Supreme Court’s decisions in Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007), and Ashcroft v. Iqbal, 556 U.S. 662 (2009), legal conclusions or speculative allegations should not be sufficient to support a preference complaint. The dollar amount of the defense against preference claims provided in section  547(c)(9) should be increased to $25,000 in the aggregate. This dollar amount should continue to be increased based on the Consumer Price Index for All Urban Consumers under section 104(a). The small claims venue provision in 28 U.S.C. § 1409(b) should be amended to (i)  clarify that the section applies to preference actions under section 547 and (ii)  increase the dollar limit for debts (excluding consumer debts) against noninsiders to $50,000 in the aggregate. This dollar amount should continue to be increased based on the Consumer Price Index for All Urban Consumers under section 104(a).  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 155 of 402 ABI Commission to Study the Reform of Chapter  Preference Claims: Background The concept of preference law dates back to the 1584 English King’s Bench decision, The Case of Bankrupts (finding postpetition transfers ineffective against a bankrupt’s estate)545 and the 1768 decision of Alderson v Temple (authorizing the recovery of property preferred to a particular creditor).546 Since that time, the law has undergone numerous variations with regard to the underlying purpose of the transfer, the necessary intent of the parties, and the insolvent state of the debtor at the time of the transfer. In 1978, Congress revised the preference law to omit the requirement that the trustee547 establish that the creditor had reasonable cause to believe the debtor was insolvent, in exchange for the reduction of the noninsider reachback period from 120 to 90 days and the addition of a 90-day presumption of insolvency. The primary goals of preference law are (i) to equalize distribution and (ii) to maximize estate value.548 It seeks to achieve these goals through property recapture and deterrence.549 Under the Bankruptcy Code’s original conception of preference law, the trustee could recover payments or property transferred to creditors prepetition to the extent those transfers preferred such creditors over other similarly situated creditors (typically general unsecured creditors).550 The trustee would then distribute the recovered value to all similarly situated creditors. Even the creditors from which the trustee recovered preferences were, in many instances, entitled to receive a pro rata share of the recovered value.551 16 1, 20 ber 2 Since 1978, the application of preference law has changed. Someem v commentators question whether n No 552 ived o preference law continues to serve its original goals. rchThese commentators suggest that preference a 363 law is not an effective deterrent and does 14-35 . not necessarily equalize distributions. In fact, anecdotal , No o n evidence shows that, in manyhcases, w value of preference recoveries no longer is reallocated among v. Br the set general unsecured d in Blix e creditors. Rather, secured creditors are granted liens in preference claims and cit recoveries as part of adequate protection, cash collateral, or debtor in possession financing orders in the case.553 Alternatively, the estate may not have sufficient resources to pay administrative and priority claims in the case, and the trustee applies preference recoveries to these claims.554 Moreover, 545 7 Eng. Rep. 441 (K.B. 1584). 546 96 Eng. Rep. 384 (K.B. 1768). 547 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. 548 John C. McCoid, Bankruptcy, Preferences, and Efficiency: An Expression of Doubt, 67 Va. L. Rev. 249, 261 (1981). 549 Id. at 262. 550 See, e.g., G.H. Leidenheimer Baking Co., Ltd. v. Sharp (In re SGSM Acquisition Co., LLC), 439 F.3d 233, 238 (5th Cir. 2006) (“The theory is that when the preferential payments are returned, all creditors can share ratably in the debtors’ assets, and the race to the courthouse, or the race to receive payment from a dwindling pre-bankruptcy estate, will be averted.”). 551 For examples of statutory authority for such distributions, see Section 57g of the Bankruptcy Act and section 502(h) of the Bankruptcy Code. 552 See, e.g., Brook E. Gotberg, Conflicting Preferences in Business Bankruptcy: The Need for Different Rules in Different Chapters, 100 Iowa L. Rev. 51 (2014). 553 Terry Brennan, Miller: Liquidations Set to Rise, The Deal, Dec. 2, 2003, available at 2003 WLNR 4666298; Kenneth N. Klee & Richard Levin, 21 Norton J. Bankr. L & Prac. 5, §§ 3.0, 3.6 (Nov. 2012); see Thomas D. Goldberg, Curbing Abusive Preference Actions — Rethinking Claims on behalf of Administratively Insolvent Estates, Am. Bankr. Inst. J., May 2004, at 14.Goldberg. See also In re Furr’s Supermarkets, Inc., 373 B.R. 691, 697 (B.A.P. 10th Cir. 2007) (proceeds of avoidance actions split between secured lender and administrative claims); Mellon Bank, N.A. v. Dick Corp., 351 F.3d 290, 294 (7th Cir. 2003), cert. denied, 541 U.S. 1037 (2004) (proceeds of avoidance actions used solely to pay claims of secured lenders); In re Payless Cashways, Inc., 290 B.R. 689, 696–97 (Bankr. W.D. Mo. 2003) (preference action recoveries solely to satisfy administrative claims). 554 Companies increasingly utilize easy to obtain prepetition financing, through mezzanine funding, leveraged lending, second lien debt, and securitization, such that potential debtors are now contemplating bankruptcy with extremely leveraged balance sheets. As a result, little, if any, unencumbered collateral is often available to offer prospective DIP lenders. See Stephen A. Donato & Thomas L. Kennedy, Trends in DIP Financing: Not as Bad as It Seems?, J. Corp. Renewal, Sept/Oct. 2009, ¶¶ 11–12, available at http://www.turnaround.org/Publications/Articles.aspx?objectId=11602. See also Goldberg, supra note 553, at 14. V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 156 of 402 Bankruptcy Institute trustees may pursue preference claims in situations in which a cost-benefit analysis indicates little value for the estate, but significant cost and burden for the targeted creditors. Preference Claims: Recommendations and Findings Preference law is one aspect of a chapter 11 case that affects creditors on an individual basis. Unlike other aspects of bankruptcy law that generally affect creditors’ rights, preference law challenges transfers made to a particular creditor and may require that creditor to disgorge prepetition payments to the estate. The Commissioners acknowledged that from the unsecured creditor’s perspective, preference law appears unfair and potentially increases the losses by that particular creditor as a result of the chapter 11 case, particularly if preference recoveries are not available to pay general unsecured claims. The Commission reviewed the testimony from the various public hearings, which evidenced strong frustrations with preference law. Witnesses testified that some trustees pursued preference actions with little diligence and without regard to the merits of the underlying claim.555 They suggested that, at least from an outside perspective, some trustees appear to file preference actions not necessarily to recover the alleged preference, but to extract a settlement payment.556 The Commissioners discussed different options for addressing these concerns and enhancing the efficiency of the preference process,557 as well as the potential abuses associated with each.558 6 1 1, 20 ber 2 m Under section 547 of the Bankruptcy Code, the trustee currently Nove the burden of proving the n bears ed o rchiv elements of a preference claim under section 547(b), and then the creditor bears the burden of 63 a -353 4 proving one of the affirmative defenseswn, No. 1 in section 547(c). The Commission considered contained ro supplementing the elements liof eth v. B 547(a) with an affirmative statement concerning diligence section B xs d in ethe merits of the preference claim in light of any section 547(c) defenses performed to evaluate cit available to the creditor. Alternatively, some of the Commissioners suggested a presumption in favor of the creditor that the prepetition transfer was in the ordinary course of business, which the trustee could rebut as part of its prima facie case.559 Although the Commissioners found potential utility 555 See Oral Testimony of Kathy Tomlin: NACM Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 27–29 (May 21, 2013) (NACM Transcript) (noting how she spends tremendous time and resources successfully defending preference actions and arguing that trustees and debtors should have an obligation to evaluate preference claims and defenses before making a repayment demand), available at Commission website, supra note 55; Oral Testimony of Joe McNamara: NACM Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 12 (May 21, 2013) (NACM Transcript) (providing specific example of time and costs associated with preference action in a particular case), available at Commission website, supra note 55. 556 See Oral Testimony of Valerie Venable: NACM Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 34–37 (May 21, 2013) (NACM Transcript) (“The trustee knows [that preference defense] is going to get expensive to me to continue to defend and is counting on a monetary settlement just to get rid of them.”), available at Commission website, supra note 55. 557 The Commissioners also discussed eliminating the preference statute in its entirety but that principle was rejected. The Commissioners agreed that any such elimination would only accelerate the prepetition depletion of a debtor’s assets. 558 In re Ames Dep’t Stores, Inc., 450 B.R. 24 (Bankr. S.D.N.Y. 2011), aff ’d, 470 B.R. 280 (S.D.N.Y. 2012), aff ’d, 506 Fed. App’x 70 (2d Cir. 2012), cert. denied, 134 S. Ct. 65 (2013). 559 First Report of the Commercial Fin. Ass’n to the ABI Comm’n to Study the Reform of Chapter 11: Field Hearing at Commercial Fin. Ass’n Annual Meeting, at 12 (Nov. 15, 2012) (“Since 1978, it has become common in cases of any size that post-confirmation liquidation trustees or post-conversion chapter 7 trustees assert claims against all creditors who received payments from the debtor within 90 days before the commencement of the case that those payments may be avoidable preferences. In some, but not all, such cases, the trustees at least perform new value analyses and claim only the net balance; in virtually no cases do the trustees assess the likelihood of an ordinary course defense. There are usually exchanges of letters and spreadsheets resulting in settlements for a fraction of the amount of the original claims. Often, the creditors settle for nuisance value just to avoid the costs of litigation. This practice imposes costs on creditors vastly disproportionate to the gain to estates, and is particularly difficult for factors who do not have direct access to the original vendors’ records. Since factors are a major source of financing for small and medium sized firms, this burden should be of concern to everyone. Requiring the trustees to plead that challenged transfers were not in the ordinary course or subject to new value setoff would reduce the number and burden of weak claims without imposing undue burdens on the trustees. The same records that allow the trustees to identify the payments they question would also allow  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 157 of 402 ABI Commission to Study the Reform of Chapter  in each option, they raised concerns regarding a trustee’s ability to obtain information sufficient to make affirmative statements or rebut such a presumption as part of its prima facie case. Some of the Commissioners noted that, in many cases, the books and records of the debtor do not provide the information necessary to make these assessments at the outset, and that trustees typically perform due diligence and make good faith attempts to assess the merits of the potential preference action before filing the complaint against, or issuing a demand letter to, the creditor. These Commissioners acknowledged the concerns of the hearing witnesses, but believed those represented the exception rather than the rule concerning a trustee’s pursuit of preference claims. The Commission reviewed the steps commonly taken by trustees in evaluating preference claims to try to develop a threshold standard that would not be unduly burdensome on trustees, but also would provide some protection to creditors in the process. The Commission ultimately determined that codifying a standard that required the trustee to perform reasonable due diligence and to make good faith efforts to evaluate the merits of the preference claim was a reasonable compromise. It also agreed that the statute should require the trustee to plead with particularity in the complaint the facts supporting each element of the preference claim under section 547(b), in accordance with the U.S. Supreme Court’s decisions in Bell Atlantic Corp. v. Twombly and Ashcroft v. Iqbal,560 which provide that legal conclusions or speculative allegations should not be sufficient to support a complaint. Finally, the Commission recommended increasing the monetary caps in section 547(c)(9) of the Bankruptcy Code and section 1409(b) of title 28 of 16 1, 0 the U.S. Code (the small claims venue provision) to $25,000 and $50,000,2respectively (indexed in ber 2 vem accordance with section 104(a) of the Bankruptcy Code). oTheoCommission voted to recommend nN ed rchiv these three changes. The Commissioners firmly believed that these changes collectively would 63 a -353 14 mitigate many of the perceived or actualoabuses in the preference process. N . wn, h v. xset n Bli i Bro The Commissionited reviewed the potential impact of fee shifting or sanctions in the context of c also preference litigation. Many of the Commissioners did not support a straight “loser pays” rule, as it could penalize preference defendants in close cases when the claims were disputed and the creditor loses. The Commissioners were also concerned about requiring the estate to pay when the trustee loses on a preference claim because of the nature of preference litigation, which often is uncertain and involves trustees initially working with limited information, and the harm to other beneficiaries of the estate. The Commission determined that neither fee shifting nor sanctions were warranted or workable in the preference context. 2. Recoveries Under Section 550 Recommended Principles: The trustee should be permitted to name an alleged subsequent transferee as a defendant in the original complaint to avoid any transfer under Bankruptcy Code section 544, 545, 547, 548, 549, or 553(b), and to recover such property under them to assess sufficiently for Rule 9011 purposes the ordinary course and new value issues at little additional cost to them. On the other hand, the savings to factors and other creditors that would result from weeding out weak claims before they are even asserted would be substantial.”), available at Commission website, supra note 55. 560 Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007); Ashcroft v. Iqbal, 556 U.S. 662 (2009). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 158 of 402 Bankruptcy Institute section 550. If any alleged subsequent transferee is not named as a defendant in the original complaint, the trustee should be required to sue such transferee in a subsequent action under section 550, and such transferee should have the ability to raise any and all defenses, including those relating to the original avoidance action, in that litigation. Section 550 should be amended accordingly. The term “for the benefit of the estate” under section 550(a) should be interpreted broadly to permit recoveries for the benefit of “all creditors according to their statutory and contractual entitlements.” Mellon Bank, N.A. v. Dick Corp., 351 F.3d 290, 293 (7th Cir. 2003), cert. denied, 541 U.S. 1037 (2004). This interpretation of section 550(a) should include all creditors, including administrative claimants and prepetition equity security holders, but should not include lenders under a postpetition financing facility. See Section IV.B, Financing the Case. It also should not expand or otherwise affect the underlying causes of action that a trustee must establish prior to seeking recoveries under section 550. The trustee should be able to file an action under chapter 5 of the Bankruptcy Code to avoid and recover transfers occurring outside the United States to the same extent it could file such an action with respect to domestic transfers. In reviewing any avoidance action involving transfers occurring solely outside the United States, the 16 1, 20 court should consider whether allowing such action to proceedeis2consistent with b r m general principles of comity and is reasonably necessary Nove n to protect the interests of ed o iv the estate, considering the expectations of3thearch 63 defendants, the laws of the foreign -35 4 jurisdiction, and the relief available o. 1the trustee in the foreign jurisdiction. N to wn, cited h v. xset n Bli i Bro Recoveries Under Section 550: Background Section 550 of the Bankruptcy Code complements the trustee’s chapter 5 avoiding powers by allowing the trustee561 to recover the property involved in, or the value of, any avoided transfers.562 For example, a debtor in possession may avoid preferential transfers under section 547 or fraudulent transfers under section 548 or 544(b) and then seek to recover the security interest, lien, asset, or money transferred in those avoided transactions under section 550. Specifically, section 550(a) provides as follows: (a) Except as otherwise provided in this section, to the extent that a transfer is avoided under section 544, 545, 547, 548, 549, 553(b), or 724(a) of this title, the trustee may recover, for the benefit of the estate, the property transferred, or, if the court so orders, the value of such property, from — (1) the initial transferee of such transfer or the entity for whose benefit such transfer was made; or 561 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. 562 11 U.S.C. § 550.  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 159 of 402 ABI Commission to Study the Reform of Chapter  (2) any immediate or mediate transferee of such initial transferee.563 Section 550 establishes a two-step process: the debtor in possession first files a complaint to avoid the subject transfer or transaction; and then, after the court grants the relief requested by the complaint, the debtor in possession files a separate action to recover the property (or the value of the property) involved in the avoided transfer or transaction. Although the debtor in possession may assert the avoidance action and the recovery action against the transferee in the same complaint, the language of the statute suggests that a separate action must be filed against any subsequent transferees.564 Some courts also are uncertain whether a debtor in possession is authorized to seek to recover property from foreign subsequent transferees under section 550.565 In addition, courts are divided concerning the interpretation of the phrase “for the benefit of the estate” as used in section 550.566 Some courts interpret the phrase broadly, permitting recovery as soon as there is some identifiable benefit to the estate.567 Other courts utilize a narrower interpretation, restricting recoveries to those circumstances in which a more direct benefit to creditors (at times, specifically unsecured creditors) can be shown.568 The Fifth, Seventh, and Tenth Circuits, as well as certain lower courts within those Circuits, interpret section 550 broadly.569 These courts hold that there is a benefit to the estate when any interested party in a bankruptcy case stands to benefit from avoidance action recoveries.570 The term 1 “interested party” has been interpreted not only to include secured creditors,6unsecured creditors, 1, 20 ber 2 vem and administrative claimants,571 but also equity security holders.572 In addition, the benefit to the n No ed o rchiv estate does not need to be direct, but may arise indirectly by, for example, increasing the likelihood 63 a -353 . of effectuating a successful reorganization 14 meeting payment obligations under a plan.573 , No or 563 564 565 566 567 568 569 570 571 572 573 h v. xset n Bli i cited n Brow Id. Id. See Sec. Investor Prot. Corp. v. Bernard L. Madoff Inv. Sec. LLC, 2014 U.S. Dist. LEXIS 91508 (S.D.N.Y. July 6, 2014). See e.g., In re Acequia, Inc., 34 F.3d 800, 811–12 (9th Cir. 1994). In re C.W. Mining Co., 477 B.R. 176, 189 (B.A.P. 10th Cir. 2012), aff ’d, 749 F.3d 895 (10th Cir. 2014) (explaining that the phrase “for the benefit of the estate,” as used in section 550, should be construed broadly, rather than narrowly, to include indirect benefits). See also Weaver v. Aquila Energy Marketing Corp., 196 B.R. 945, 956 (S.D. Tex. 1996) (noting that section 550’s “benefit” requirement is satisfied as soon as there is some identifiable benefit to the estate). See In re Burlington Motor Holdings, Inc., 231 B.R. 874, 877 (Bankr. D. Del. 1999) (holding that “any recovery of preferences in this case will benefit only the Successor Corporation” and that “unsecured creditors must be benefitted by recovery”) (citing In re Resorts Int’l, Inc., 145 B.R. 412, 474–75 (Bankr. D.N.J. 1990)); Harstad v. First Am. Bank, 39 F.3d 898, 905 (8th Cir. 1994) (holding that “ increas[ing] the likelihood that [debtors] will be able to pay their creditors as the Plan requires, even though it will not increase the amount paid to the creditors” is insufficient benefit to the estate to permit recovery under section 550(a)). Mellon Bank, N.A. v. Dick Corp., 351 F.3d 290, 293 (7th Cir. 2003), cert. denied, 541 U.S. 1037 (2004) (holding that the term “estate,” as used in section 550(a), means the set of all potentially interested parties, and not any one particular class of creditors); In re NETtel Corp., Inc., 364 B.R. 433, 442 (Bankr. D.C. 2006); In re Furrs, 294 B.R. 763, 783 (Bankr. D. N.M. 2003). See MC Asset Recovery LLC v. Commerzbank A.G. (In re Mirant Corp.), 675 F.3d 530, 532–34 (5th Cir. 2012); Mellon Bank, N.A. v. Dick Corp., 351 F.3d 290, 293 (7th Cir. 2003), cert. denied, 541 U.S. 1037 (2004); In re NETtel Corp., Inc., 364 B.R. 433, 442 (Bankr. D. D.C. 2006). Silverman Consulting, Inc. v. Hitachi Power Tools, U.S.A., Ltd. (In re Payless Cashways, Inc.), 290 B.R. 689, 696–97 (Bankr. W.D. Mo. 2003) (holding that a chapter 11 trustee had standing to pursue preference claims even though recoveries would go solely to satisfy administrative claims). See Kipperman v. Onex Corp., 411 B.R. 805, 876–88 (N.D. Ga. 2009) (holding that all interests, including those of all creditors and equity security holders, are comprised in the estate); In re Bayou Grp., LLC, 372 B.R. 661, 664 n. 2 (Bankr. S.D.N.Y. 2007) (refusing to adopt a bright-line rule that avoidance actions can never be brought in whole or in part for the benefit of equity security holders). In re P.A. Bergner & Co., 140 F.3d 1111, 1118 (7th Cir. 1998), cert. denied, 525 U.S. 964 (1998) (explaining that though preference action recovery will benefit reorganized debtor and thus owners of reorganized debtor, recovery under section 550(a) is permissible because owners of reorganized debtor were the largest creditor group of old debtor, so benefit to these creditors provides a sufficient benefit to the estate to satisfy the requirements of section 550); In re Furrs, 294 B.R. 763, 780 (Bankr. D.N.M. 2003) (holding that “an action which will generate funds for the payment of administrative claims is a proper use of [t]rustee’s avoiding and recovery powers”). See also Weaver v. Aquila Energy Marketing Corp., 196 B.R. 945, 956 (S.D. Tex. 1996) (holding that section 550’s “benefit” requirement is satisfied as soon as there is some identifiable benefit to the estate). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 160 of 402 Bankruptcy Institute Courts narrowly interpreting section 550(a) do not require an absolute direct benefit to unsecured creditors, but they generally require a more direct benefit to those creditors than do courts that employ the broader interpretation.574 For example, the Eighth Circuit575 and the Bankruptcy Court for the District of Delaware576 have interpreted section 550(a) as effectively requiring that the contemplated recovery be somehow targeted, or legally tied, to the benefit of creditors (e.g., pursuant to a plan in which avoidance action proceeds are distributed or in a settlement under Bankruptcy Rule 9019). In both cases, the courts found that the demonstrated benefit was insufficient to permit recovery under section 550(a).577 Recoveries Under Section 550: Recommendations and Findings The Commission reviewed several issues relating to avoidance action recoveries under section 550. This section of the Bankruptcy Code is an integral component of the trustee’s avoiding powers under chapter 5 of the Bankruptcy Code. It essentially represents the mechanism by which the trustee can recover any value resulting from avoidance actions for the estate. Recognizing the section’s importance in the avoidance process and the need to provide a clear, efficient, and fair path to recoveries, the Commissioners discussed the actual mechanics of section 550. Several Commissioners commented on the sometimes cumbersome process of suing on the underlying avoidance action and then bringing the recovery action under section 550 after the fact. 016 Many of the Commissioners believed that providing subsequent transferees 1, 2 at least notice of ber 2 with em n would the underlying avoidance action and an opportunity to intervene Nov improve this system. This ed o hiv kind of notice would prevent duplicative litigation5363 arcno notice is provided, and a subsequent when -3 14 transferee disputes the existence of a valid, No. of action. Others suggested requiring the trustee cause rown B h to name any potential subsequentv.transferees as defendants in the underlying avoidance action. xset n Bli i cited Some of the Commissioners questioned whether such a requirement was feasible, because often the identity of any subsequent transferees is discovered in the litigation on the underlying avoidance claim and is not necessarily known to the trustee at the time of filing the complaint. Notice would not be possible in those cases. 574 See, e.g., In re Acequia, Inc., 34 F.3d 800, 811 (9th Cir. 1994) (allowing recovery of fraudulent transfers even though creditors have been paid in full when recovery would aid continuing performance under plan and pay administrative creditors because “[c]ourts construe the ‘benefit to the estate’ requirement broadly, permitting recovery under section 550(a) even in cases where distribution to unsecured creditors is fixed by a plan of reorganization and in no way varies with recovery of avoidable transfers”); Harstad v. First Am. Bank, 39 F.3d 898, (8th Cir. 1994) (“We do not hold that a bankruptcy trustee or a debtor in possession (or a debtor or an appointed representative under powers reserved via § 1123(b)(3)) must demonstrate a direct benefit to the creditors in the form of a distribution to the creditors of the preference recovery (although that would certainly make this a much easier issue to decide). Nevertheless, we do hold that those wishing to bring preference actions must show a more definite benefit to creditors than the [debtors] have shown here.”); Wellman v. Wellman, 933 F.2d 215, 218 (4th Cir. 1991), cert. denied, 502 U.S. 925 (1991) (holding that there is no benefit to the estate “when the result is to benefit only the debtor rather than the estate”); Adelphia Recovery Trust v. Bank of Am., N.A., 390 B.R. 80, 94 (S.D.N.Y. 2008), aff ’d, 379 Fed. App’x 10 (2d Cir. 2010), cert. dismissed, 131 S. Ct. 896 (2011) (“[I]t is well settled in the Second Circuit, that avoiding powers may be exercised by a debtor in possession only for the benefit of creditors, and not for the benefit of the debtor itself.”) (citations omitted) (internal quotation marks omitted); Trans World Airlines, Inc. v. Travellers Int’l AG (In re Trans World Airlines, Inc.), 163 B.R. 964, 972 (Bankr. D. Del. 1994) (“[T]he Code clearly contemplates the use of avoidance action recoveries in the operation of the business in a manner which only indirectly benefits creditors.”). 575 Harstad v. First Am. Bank, 39 F.3d 898, 904–05 (8th Cir. 1994). 576 In re Burlington Motor Holdings, Inc., 231 B.R. 874, 877 (Bankr. D. Del. 1999) (“[The] Plan does not delegate preference recoveries to the estate or list them as a source of funds designated to pay down the Note. Rather, any recovery of preferences in this case will benefit only the Successor Corporation.”). 577 See Harstad v. First Am. Bank, 39 F.3d 898, 904–05 (8th Cir. 1994); In re Burlington Motor Holdings, Inc., 231 B.R. 874, 877 (Bankr. D. Del. 1999).  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 161 of 402 ABI Commission to Study the Reform of Chapter  Given those obstacles, the Commissioners discussed whether the federal notice standards as articulated by the U.S. Supreme Court in Mullane v. Central Hanover Bank & Trust Co. would suffice.578 The Mullane standard basically requires notice by means “reasonably calculated, under all the circumstances, to apprise the interested parties of the pendency of the action, and afford them an opportunity to present their objections.”579 The Commission determined, however, that to the extent the trustee would be seeking to recover value from the subsequent transferees, actual notice should be required. Based on these considerations, the Commission recommended clarifying section 550 to permit the trustee to name a subsequent transferee as a defendant in the original, underlying cause of action and, if not named, to require the trustee to sue the subsequent transferee in a subsequent action, at which time the subsequent transferee should be permitted to assert defenses to the original avoidance cause of action. The Commissioners then analyzed the extra-territorial application of the trustee’s avoiding powers and recovery rights under section 550 to subsequent transferees. The Commissioners acknowledged the primary competing interests at stake: the perceived unfairness in permitting avoidance of transfers made to parties within the United States, but then precluding that remedy as to any subsequent transferees overseas; and the reasonable expectations of foreign transferees, particularly those who may not know that the transfer originated from the debtor, including the expectation that any payments they received were governed by the laws of their respective jurisdictions. The Commissioners methodically walked through examples when this issue may present itself. They 16 1, 20 considered situations were a feeder fund is the initial transferee and 2noted the relevance of the ber vem solvency of the feeder fund. They examined the facts of the Madoff and Maxwell cases and discussed n No ed o rchiv the factual nuances of these cases.580 The Commissioners acknowledged and appreciated the delicate 63 a -353 4 balance required in these instances.wn, No. 1 h v. xset n Bli i Bro The Commissioners discussed how best to balance the competing interests with well-established cited principles of comity. The Commissioners generally agreed with the notion that foreign transfers should be subject to the chapter 5 avoiding powers, but only if such application was consistent with principles of comity. Accordingly, the Commission approved the recommendation that section 550 cover domestic or foreign subsequent transferees extra-territorially to the same extent as domestic subsequent transferees, but agreed that the court should consider whether allowing such action to proceed is consistent with general principles of comity and is reasonably necessary to protect the interests of the estate considering the expectations of the defendants, the laws of the foreign jurisdiction, and the relief available to the trustee in the foreign jurisdiction. Once a trustee identifies potential avoidance and recovery actions under chapter 5 of the Bankruptcy Code, courts have differed on whether the trustee may pursue those actions if recoveries will go to stakeholders other than general unsecured creditors. The Commissioners discussed the origins of the concept that avoidance action recoveries should inure only to the benefit of general unsecured creditors and whether such a limited purpose aligned with the concept of the estate.581 The Commissioners discussed witness testimony that supported limiting the beneficiaries of preference 578 Mullane v. Central Hanover Bank & Trust Co., 339 U.S. 306, 314 (1950). 579 Id. 580 See, e.g., In re Maxwell Commc’n Corp., 93 F.3d 1036, 1047–48 (2d Cir. 1996); Sec. Investor Prot. Corp. v. Bernard L. Madoff Inv. Sec. LLC, 2014 U.S. Dist. LEXIS 91508 (S.D.N.Y. July 6, 2014). 581 See, e.g., Mellon Bank NA v. Dick Corp., 351 F.3d 290, 293 (7th Cir. 2003), cert. denied, 541 U.S. 1037 (2004) (explaining that section 550 “speaks of benefit to the estate — which in bankruptcy parlance denotes the set of all potentially interested parties”). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 162 of 402 Bankruptcy Institute actions to unsecured creditors. They also considered whether administrative claimants or old equity should be permitted to benefit from recoveries under section 550. The Commissioners drew on the facts and holding in Mirant Corp., in which the Fifth Circuit interpreted section 550(a) and found that “[a] bankruptcy trustee may still have standing to avoid a fraudulent transfer after the unsecured creditors are satisfied in full.”582 The Commissioners found the reasoning of courts following a broader interpretation of section 550(a) to be sound and consistent with the general concept of the bankruptcy estate. The estate does not represent only general unsecured creditors in a case, but often represents a variety of stakeholders whose interests also may have been harmed by improper transfers and transactions subject to avoidance under chapter 5 of the Bankruptcy Code. The Commission voted to endorse a broad interpretation of the term “for benefit of the estate” in section 550(a) to mean all parties with claims against, or interests in, the estate, including administrative claimants and old equity but not including claims of postpetition secured creditors. In reaching this conclusion, however, the Commission agreed that this principle only affected a trustee’s action for recoveries against transferees under section 550; it did not expand or otherwise affect a trustee’s underlying cause of action under section 544, 545, 547, 548, 549, or 553(b). D. Labor and Benefits 16 1, 20 ber 2 vem n No ed o rchiv 63 a -353 . 14 , No rown .B eth v Blixs 1. Collective Bargaining Agreements n UnderciSection 1113 ted i Recommended Principles: Disputes regarding modification and rejection of a company’s collective bargaining agreements can be time-consuming, expensive, and litigious. These disputes also can be emotionally charged and disruptive at key points in the chapter 11 process. Moreover, and perhaps most importantly, they involve a resource many consider critical to a company’s successful restructuring — its employees. Accordingly, the Bankruptcy Code should be amended to further the objectives of negotiation and consensual resolution underlying the collective bargaining process and section 1113. To that end, section 1113 should be amended to add requirements that, in addition to the provisions of section 1113(b)(1), the trustee should: (i) provide notice to the applicable labor organization(s) that modifications to the collective bargaining agreement are being proposed along with an initial proposal and description of the information to be made available for the labor organization to evaluate the proposal; and (ii) file a notice of intent to initiate proceedings under section 1113(b) 582 MC Asset Recovery LLC v. Commerzbank A.G. (In re Mirant Corp.), 675 F.3d 530, 534 (5th Cir. 2012).  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 163 of 402 ABI Commission to Study the Reform of Chapter  and schedule an initial conference with the court regarding such proceedings. The foregoing is intended to promote transparency, disclosure, and communication among the parties, and to provide a reasonable time to conduct negotiations in an effort to reach a consensual agreement prior to the commencement of any litigation by the trustee to reject the collective bargaining agreement. Accordingly, section 1113 should be amended as follows: o The trustee should file a request for an initial conference regarding the initiation of section 1113 proceedings with the court and serve the request on the authorized representative of the affected employees (the “authorized representative”) and any other party entitled to notice of matters pending in the case under the Bankruptcy Rules. In the request, the trustee should certify that it has provided the authorized representative with a written copy of its initial proposal and the other information required by section 1113(b)(1). o The court should set a status conference to discuss the process with the trustee and the authorized representative. This conference should be scheduled so as to allow the authorized representative sufficient time to (i) review the trustee’s notice, initial proposal, and proposed information disclosures; and (ii) meet and confer with the trustee to discuss a timetable for conducting negotiations, any information-related1,matters, and any 2016 ber 2 including whether other particulars relevant to the conduct of negotiations, vem n No ed o in their discussions. The court the parties believe a mediator wouldhassist rc iv 63 a -353 should conduct the initial1conference on or before 30 days after the filing of . 4 , No rownfor an initial conference. the trustee’shrequest v. B xset n Bliinitial conference, the trustee and the authorized representative i o iAt the c ted should be prepared to: (i) discuss the timetable for conducting negotiations over the proposal; (ii) resolve any initial issues regarding the disclosure of information relevant for the evaluation of the proposal; (iii) identify any issues regarding the resources available to the parties so that they may engage in informed discussions regarding the request for modifications; (iv) discuss whether the participation of a mediator would assist the parties; and (v) discuss any other issues that may present obstacles to conducting informed, good faith negotiations regarding the trustee’s request for modifications. The court may also wish to establish an expedited process for the resolution of any information-related disputes. o If, following a reasonable period of time and consistent with the timetable established at the initial conference (which should take into consideration the nature and scope of the modification proposal), the parties have not reached an agreement regarding mutually acceptable modifications, the trustee may request a further status conference in order for the parties to report to the court regarding the status of the process and for the trustee to request a case management process for a motion to reject the collective bargaining agreement. At such status conference, the court should set a date by which the trustee and the authorized representative would submit V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 164 of 402 Bankruptcy Institute a case management and scheduling order. The proposed hearing schedule may incorporate a bifurcation of the trial into an initial hearing schedule for the presentation of the trustee’s case and then, following an adjournment, a second hearing schedule for the authorized representative to present its case. The scheduling order may provide for the (continued) participation of a mediator to facilitate discussions between the parties if requested by the parties or otherwise warranted under the circumstances. The court should schedule the start of the trial on the motion to reject the collective bargaining agreement on or before 180 days after the filing of the trustee’s request for an initial conference, unless the trustee and the authorized representative agree to extend, or the court for cause extends, this deadline. The parties should factor this trial deadline into the timetable established at the initial conference. o Statutory committees should be able to attend and observe any status conferences conducted under this principle, but participation, including at any hearing on rejection, should be limited to receiving and reviewing information from the trustee and the authorized representative and evaluating the trustee’s business judgment regarding the decision to seek rejection under section 1113. Statutory committees would also be heard in 6 the usual manner in connection with any settlement reached 201 1, between the ber 2 vem trustee and the authorized representative. n No ed o chi o The foregoing recommendations should rnotvbe read to, and are not intended 63 a -353 to, alter current law with ,respect to section 1113(e). o. 14 n N Brow th v. lixse of a collective trustee’s rejection in B cited The bargaining agreement under section 1113 should be treated as a breach of such agreement. The authorized representative may assert a claim for monetary damages arising from the rejection of the collective bargaining agreement against the estate, on behalf of the affected employees, which claim should be a general unsecured claim, if the rejection order occurs prior to assumption of the agreement, similar to the assertion of rejection damages claims by counterparties to contracts rejected under section 365 pursuant to sections 365(g) and 502(g). Any such rejection damages claims should be determined in accordance with applicable nonbankruptcy law for breach of contract and subject to mitigation. Collective Bargaining Agreements Under Section 1113: Background The U.S. Supreme Court’s decision in N.L.R.B. v. Bildisco resolved disparate rulings among the lower courts regarding the treatment of collective bargaining agreements in bankruptcy.583 In Bildisco, the Supreme Court reaffirmed the characterization of a collective bargaining agreement as an executory contract subject to rejection under section 365 of the Bankruptcy Code.584 The Supreme Court also 583 N.L.R.B. v. Bildisco & Bildisco, 465 U.S. 513 (1984), superseded by statute, Public Law 98-353 (section 1113 of the Bankruptcy Code), as recognized in N.L.R.B. v. Manley Truck Line, Inc., 779 F.2d 1327, 1331 n. 7 (7th Cir. 1985). 584 Id. at 522–23.  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 165 of 402 ABI Commission to Study the Reform of Chapter  held that, in recognition of the “special nature” of a collective bargaining agreement, the debtor in possession’s585 proposed rejection of a collective bargaining agreement was subject to a “somewhat stricter standard” of review than the generally applicable business judgment standard.586 The Court rejected a very strict standard proposed by the National Labor Relations Board, which was adopted by the Second Circuit in REA Express,587 i.e., that the debtor in possession should not be permitted to reject a collective bargaining agreement unless it can show that rejection is necessary to prevent the liquidation of the debtor. Instead, the Court endorsed a standard that it viewed as “somewhat higher than that of the ‘business judgment rule’ but a lesser one than that embodied in the REA Express opinion.”588 The Court also held that a debtor in possession’s unilateral modification of a collective bargaining agreement prior to court approval of the rejection was not an unfair labor practice in violation of the National Labor Relations Act (the “NLRA”).589 Congress enacted section 1113 of the Bankruptcy Code in direct response to the Bildisco decision.590 Section 1113 establishes particularized rules regarding the treatment of collective bargaining agreements when an employer is in chapter 11.591 Among other things, section 1113 establishes special procedures and standards that are applicable when a debtor in possession seeks to modify, or ultimately reject, a collective bargaining agreement. The statute prescribes a process of bargaining between the debtor in possession and the authorized representative of the affected employees as a prerequisite to seeking court-approved rejection. In the absence of an agreed-upon resolution regarding the debtor in possession’s proposed modifications, the debtor in possession may seek 16 1, 2 the court-approved rejection. In doing so, the debtor in possession must rmeet 0 rejection standards be 2 vem set forth in the statute in order to obtain court approval, including demonstrating compliance with n No ed o iv arch the statutory bargaining requirements.592 5363 -3 o. 14 n, N Brow th v. 585 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 lixse in and of the BankruptcytCode, B implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. ci ed See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. 586 Id. at 524 (“We agree with these Courts of Appeals that because of the special nature of a collective-bargaining contract, and the consequent ‘law of the shop’ which it creates, [citation omitted] a somewhat stricter standard should govern the decision of the Bankruptcy Court to allow rejection of a collective-bargaining agreement.”). 587 Bhd. of Ry., Airline & Steamship Clerks v. REA Express, 523 F.2d 164 (2d Cir. 1975). 588 See id. at 525 (holding that bankruptcy court should permit rejection if “the debtor can show that the collective- bargaining agreement burdens the estate, and that, after careful scrutiny, the equities balance in favor of rejecting the collective bargaining agreement”). The standard adopted by the Supreme Court drew upon the rejection standard proposed by the Eleventh Circuit in In re Brada Miller Freight Sys., Inc., 702 F.2d 890 (11th Cir. 1983). 589 Id. at 532–33. The Supreme Court’s rationale was that a collective bargaining agreement, like other executory contracts, was not enforceable by the nondebtor party upon the debtor’s bankruptcy filing. The Court’s ruling meant that, where an employer in chapter 11 committed an unfair labor practice by unilaterally modifying a collective bargaining agreement on filing for bankruptcy, statutory remedies under labor law would be unavailing. See 29 U.S.C. § 158(a)(5) (providing that it shall be an unfair labor practice for an employer “to refuse to bargain collectively” with the employees’ authorized representative); id. § 158 (d) (establishing the parties’ mutual obligation to bargain collectively, including, among other things, “that no party to [a labor contract] may terminate or modify such contract” absent compliance with the statute’s requirements). 590 See In re AMR Corp., 477 B.R. 384, 405–06 (Bankr. S.D.N.Y. 2012) (relating enactment of section 1113 in response to Bildisco). See also Andrew B. Dawson, Collective Bargaining Agreements in Corporate Reorganizations,” 84 Am. Bankr. L. J., 103, 104 (2010) (same). 591 Section 1113 applies to collective bargaining agreements covered by the National Labor Relations Act, 2 U.S.C. §§ 151–169 (the “NLRA”) and to agreements covered by Title II of the Railway Labor Act, 45 U.S.C. §§ 181–188, which is applicable to the airline industry. Railroad collective bargaining agreements covered by Title I of the Railway Labor Act, 45 U.S.C.§§ 151–165, are subject to section 1167 of the Bankruptcy Code. See 11 U.S.C. § 1167. 592 In addition to the rejection requirements, and to counteract the Supreme Court’s ruling in Bildisco that unilateral modification of a collective bargaining agreement prior to court-approved rejection does not constitute an unfair labor practice, Congress amended section 1113 to prohibits the trustee from unilaterally altering or terminating any provision of a collective bargaining agreement “prior to compliance with the provisions of [section 1113].” 11 U.S.C. § 1113(f). See Shugrue v. Air Line Pilots Ass’n, Int’l (In re Ionosphere Clubs, Inc.), 922 F.2d 984, 990 (2d Cir. 1990), cert. denied, 502 U.S. 808 (1991) (reviewing section 1113(f) and concluding that “Congress intended that collective bargaining agreement remain in effect. . . after the filing of a bankruptcy petition unless and until the debtor complies with the provisions of § 1113”). See also In re Cont’l Airlines, 125 F.3d 120, 137 (3d Cir. 1997), cert. denied, 522 U.S. 1114 (1998) (finding that the “intent behind section 1113 is to preclude debtors or trustees in bankruptcy from unilaterally terminating, altering or modifying the terms of a collective bargaining agreement without following its strict mandate”). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 166 of 402 Bankruptcy Institute Thus, prior to seeking rejection, a debtor in possession must make a proposal to the authorized representative of the employees that provides relevant information necessary to evaluate the proposal, and meet and confer in good faith with the authorized representative in an attempt to reach a mutually acceptable modification to the labor contract.593 When the parties’ efforts do not result in a mutually acceptable modification to the collective bargaining agreement, the debtor in possession may seek court-approved rejection. Under section 1113, the filing of the debtor in possession’s motion to reject the collective bargaining agreement requires the court to hold a hearing within 14 days after the filing date, upon at least 10 days’ notice to the authorized representative, although the court may extend the time for commencement of the hearing for seven days or for additional periods of time when the debtor in possession and the authorized representative agree.594 The statute also sets out the standards for approval of a motion to reject a collective bargaining agreement. Under section 1113(c), the court may approve the motion to reject if the court determines that: (i) the debtor in possession complied with the statutory requirements attendant to making its proposal; (ii) the authorized representative refused to accept the debtor in possession’s proposal “without good cause”; and (iii) “the balance of the equities clearly favors rejection.”595 In evaluating the “balance of the equities” standard, courts have articulated certain factors to be considered.596 Section 1113 requires that the court enter a ruling on the motion to reject within 30 days of the date of the commencement of the hearing, unless the parties consent to an extension of this period.597 Although an early division in the interpretation of the rejection standard occurred when the Second 16 and Third Circuits issued divergent rulings on the application of the ber 21, 20 “necessary” and “fair and em equitable” standards applicable to the debtor in possession’s proposalvunder section 1113(b)(1),598 a n No ed o hiv study by Professor Andrew Dawson suggests that the6difference in interpretation has not appeared 3 arc -353 4 to impact the courts’ ultimate rulings — n, No. 1 have generally approved the debtor in possession’s courts row motion to reject under section seth v. B 599 1113(c). lix in B cited 593 See In re Pinnacle Airlines Corp., 483 B.R. 381, 404–05 (Bankr. S.D.N.Y. 2012) (describing general operation of section 1113). The particular requirements regarding the proposal, provision of information, and good faith negotiations are set forth in section 1113(b)(1)(A) (standards for proposal), section 1113(b)(1)(B) (requirement to provide “relevant information as is necessary to evaluate the proposal”), section 1113(b)(2) (requirement that trustee meet with authorized representative and “confer in good faith in attempting to reach mutually satisfactory modifications”). 11 U.S.C. § 1113(b). 594 See 11 U.S.C. § 1113(d)(1). Section 1113 requires the court to rule on a section 1113 motion to reject within 30 days of the date of the commencement of the hearing, unless the parties consent to an extension of this period. 11 U.S.C. § 1113(d)(2). 595 Id. § 1113(c). The debtor bears the burden of proof on the elements of a section 1113 motion to reject. See Truck Drivers Local 807 v. Carey Transp. Inc., 816 F.2d 82, 88 (2d Cir. 1987). 596 See e.g., Truck Drivers Local 807 v. Carey Transp. Inc., 816 F.2d 82, 93 (2d Cir. 1987) (detailing six factors to be considered in evaluating the balance of the equities). 597 In addition to the procedures set forth in section 1113(b) through (d), section 1113 also provides for emergency “interim relief ” whereby a court may authorize a debtor to make interim changes to wages, benefits, or work rules under the collective bargaining agreement “if essential to the continuation of the debtor’s business, or in order to avoid irreparable damage to the estate.” 11 U.S.C. § 1113(e). See Wheeling-Pittsburgh Steel Corp. v. United Steelworkers of Am., AFL-CIO-CLC, 791 F.2d 1074, 1088 (3d Cir. 1986) (explaining that, in enacting section 1113, “Congress recognized that there might be immediate problems of an emergency nature in individual cases” and therefore provided for “interim changes” if the court finds “that an interim change is ‘essential to the continuation of the debtor’s business, or in order to avoid irreparable damage to the estate’”) (citations omitted). See also 7 Collier on Bankruptcy ¶ 1113.02[3] (describing interim relief provision and “high standards” generally applied to requests for such relief); In re Salt Creek Freightways, 46 B.R. 347, 349–50 (Bankr. D. Wy. 1985) (explaining enactment of section 1113(e)). 598 See 11 U.S.C. § 1113(b)(1)(A). Compare Wheeling-Pittsburgh Steel Corp. v. United Steelworkers of Am., AFL-CIO-CLC, 791 F.2d 1074, 1088–89 (3d Cir. 1986) with Truck Drivers Local 807 v. Carey Transp. Inc., 816 F.2d 82, 89 (2d Cir. 1987). 599 See, e.g., Dawson, supra note 590, at 104 (collecting data on how courts interpret the factor that the proposal be “necessary to the reorganization of the debtor” and concluding that “[b]ased on data from every large publicly traded company bankruptcy between 2001 and 2007, the present study reveals that the outcome of [section] 1113 motions was the same regardless of the legal standard applied: the court granted the debtor’s motion to reject its CBA”).  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 167 of 402 ABI Commission to Study the Reform of Chapter  Collective Bargaining Agreements Under Section 1113: Recommendations and Findings For debtors with a unionized workforce, the treatment of their labor contracts may represent one of the most important and difficult decisions in the chapter 11 case.600 These contracts represent the company’s obligations to its employees and are an integral component of the company’s relationship with its employees. These contracts, however, also may impose monetary obligations on the company that it no longer can sustain in light of financial distress and its need to reorganize.601 The Commission appreciated fully the crucial considerations and potentially dynamic elements in the collective bargaining process in a chapter 11 case. In particular, the Commissioners noted that labor relations following rejection should be taken into consideration in utilizing section 1113: even if a collective bargaining agreement is ultimately rejected through the section 1113 process, the company remains obligated to continue to bargain with the authorized representative over modifications to the agreement.602 Most of the testimony received by the Commission on section 1113 issues concerned the bargaining process itself and the deadlines imposed by this section.603 Witnesses expressed concern that the statutory requirements did not, in practice, foster meaningful negotiations.604 Rather, some witnesses suggested that many debtors in possession viewed the bargaining required under the Bankruptcy Code as a means to the litigated end they desired.605 The Honorable Stephen Mitchell of the U.S. 016 Bankruptcy Court for the Eastern District of Virginia (whose cases 1included the US Airways 2 ,2 r mbe Nove on ived arch 5363 14-3 No. wn, . Bro eth v 600 Oral Testimony of the Honorable Stephen S. Mitchell: ACB Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, ixs in Bl at 13–14 (Mar. 14,t2013) (ASM Transcript) (“I have to say at the outset that I thought that the decisions I had to make in terms ci ed 601 602 603 604 605 of termination of pension plan or termination of retiree benefits or modification of a collective bargaining agreement or proving interim changes to a collective bargaining agreement were some of the toughest I’ve had to make as a judge . . . I could tell you in no other matters that have come before me in 16 years on the bench that I receive so much mail in chambers and they were profoundly affecting. I mean, I fully understood that for some people it means they themselves might end up having to file up for bankruptcy because necessary financial support was being taken away from them.”), available at Commission website, supra note 55. Written Statement of Michael Robbins: ACB Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 2 (Mar. 14, 2013) (acknowledging that there is a need for labor representatives to make meaningful economic concessions for employers to survive), available at Commission website, supra note 55. See e.g., N.L.R.B. v. Bildisco & Bildisco, 465 U.S. 513, 534 (1984), superseded by statute, Public Law 98-353 (section 1113 of the Bankruptcy Code), as recognized in N.L.R.B. v. Manley Truck Line, Inc., 779 F.2d 1327, 1331 n. 7 (7th Cir. 1985) (noting that debtor in possession remains obligated to bargain collectively with labor organization following formal approval of rejection). Written Statement of Michael Robbins: ACB Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 2–3 (Mar. 14, 2013) (“[T]he expedited schedule mandated under Section 111 creates tremendous downward pressure on wages and working conditions. . . . [T]he 1113 process has become in practice a rushed 51-day countdown to destruction of their agreements.”), available at Commission website, supra note 55. See Oral Statement of Bob Keach: ACB Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 4 (Mar. 14, 2013) (ASM Transcript) (“The predominance of Section 363 sales of substantially all the assets of debtors means that often the purchaser do not assume collective bargaining agreements or pension liabilities. This has particularly challenged the statutory regime for addressing such agreements and liabilities.”), available at Commission website, supra note 55; Oral Testimony of Robert Roach Jr.: ACB Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 51 (Mar. 14, 2013) (ASM Transcript) (“In normal contract negotiations there’s give and take, there’s talking and there’s a result at the end of it. . . . When you bargain on 1113 after a period of time, and it’s two weeks and a week after they file, it’s either you accept what the company gives you or you don’t have a collective bargaining agreement.”), available at Commission website, supra note 55. “Negotiation is you come in with a position and both sides are compromised. There is no need for the corporation to compromise in the chapter 1113 proceeding.” Id. at 58. See Oral Testimony of Debora Sutor: ACB Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 42–45 (Mar. 14, 2013) (ASM Transcript) (“Bankruptcy should only be used as a last resort. Instead . . . companies . . . are routinely placed in bankruptcy soles as a means to escape obligations and reward top executives and middle managers for simply executing a bankruptcy plan.”), available at Commission website, supra note 55; Oral Testimony of James Campbell Little: ACB Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 35 (Mar. 14, 2013) (ASM Transcript) (stating that the debtor (company) essentially had a gun to labor’s head — it was a take it or leave it proposition, not a negotiation), available at Commission website, supra note 55. V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 168 of 402 Bankruptcy Institute bankruptcy cases) also testified that the statutory deadlines simply did not work, particularly the 14-day hearing requirement.606 The Commission considered whether refinements to the statutory process would better serve the goals of the statute. Section 1113(b)(2) provides: “During the period beginning on the date of the making of a proposal provided for in paragraph (1) and ending on the date of the hearing provided for in subsection (d)(1), the trustee shall meet, at reasonable times, with the authorized representative to confer in good faith in attempting to reach mutually satisfactory modifications of such agreement.” Thus, with respect to the bargaining process, section 1113 does not provide any minimum period during which the parties must engage in good faith bargaining.607 A debtor in possession could, consistent with the statute, serve a proposal and then, subject only to the requirements of proof set forth in section 1113(c), file a rejection motion quite soon thereafter. The motion would then be subject to the statutory hearing and notice schedule. Courts and commentators have emphasized that an important goal of section 1113 is to encourage negotiated resolutions when a debtor in possession seeks modifications to its collective bargaining agreements and when litigation should be a last resort.608 And, as one court has explained, the amount of time to be allowed for negotiations “must depend on the facts and circumstances of each case.”609 The Commissioners discussed these perspectives and whether the requirements 016 , 2 currently provided er 21 emb the debtor in possession in section 1113(b) were sufficient to generate a meaningful dialogueNov between d on chive and the authorized representative. The Commissioners rgenerally agreed that the effectiveness of 3a 3536 . 14section 1113 was case dependent, but some, suggested the process could be improved by more clearly No own separating the bargaining and thehlitigation processes. These Commissioners noted that the current v. Br t lixse process often placed thed in B e bargaining and the potential litigation on parallel tracks that had the parties cit trying to reach a compromise while the debtor in possession was preparing its case to support, and the authorized representative was working to identify good cause to block, the rejection of the agreement. These Commissioners also agreed with the witness testimony that bargaining under 606 Oral Testimony of the Honorable Stephen S. Mitchell: ACB Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 13–17 (Mar. 14, 2013) (ASM Transcript) (“Section 1113 and 1114 relief actually require that the judge hold a hearing within 14 days. . . . In reality there were no 14-day hearings or even 21-day hearings in the matters that came in front of me. Everybody understood that there had to be a certain amount of discovery, we [review] the underlying financials, there are opportunities to depose each side’s experts and things like that.”), available at Commission website, supra note 55. 607 See, e.g., Oral Testimony of Robert Roach, Jr., ACB Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 25 (Mar. 14, 2013) (ASM Transcript) (stating that the current good faith negotiation requirement in section 1113 “is not adequate because negotiating in good faith just means coming to the table and talking, it doesn’t mean give or take. . . . [There may be] back and forth, but . . . no negotiation”), available at Commission website, supra note 55. 608 E.g., N.Y. Typographical Union No. 6 v. Maxwell Newspapers, Inc. (In re Maxwell Newspapers, Inc.), 981 F.2d 85, 90 (2d Cir. 1992) (explaining that the statute’s “entire thrust” is to “ensure that well-informed and good faith negotiations occur in the market place, not as part of the judicial process”); Dawson, supra note 590, at 119 (noting that the statutory “text clearly indicates that Congress preferred the outcome of negotiated settlements to labor disputes”). See also In re Century Brass Prods., Inc., 795 F.2d 265, 273 (2d Cir. 1986), cert. denied, 479 U.S. 949 (1986) (finding that section 1113 “encourages the collective bargaining process as a means of solving a debtor’s financial problems insofar as they affect its union employees”); In re Hostess Brands, Inc., 477 B.R. 378, 382 (Bankr. S.D.N.Y. 2012) ([“Section 1113’s] unique purpose is . . . to provide for expedited, good faith bargaining and, ultimately, a determination by the court, if that doesn’t occur.”); Richard H. Gibson, The New Law on Rejection of Collective Bargaining Agreements in Chapter 11: An Analysis of 11 U.S.C. § 1113, 58 Am Bankr. L. J. 325, 327 (1984) (reviewing the statute and legislative history and describing principal purpose to “discourage both unilateral action by the debtor and recourse to the bankruptcy court”). “Instead, the law seeks to encourage solution of the problem through collective bargaining.” Id. 609 Wheeling-Pittsburgh Steel Corp. v. United Steelworkers of Am., AFL-CIO-CLC, 791 F.2d 1074, 1093–94 (3d Cir. 1986) (noting that the need for haste, in and of itself, is not a determining factor, citing the interim relief provision under section 1113(e) which is available to address emergency situations).  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 169 of 402 ABI Commission to Study the Reform of Chapter  section 1113 could be shallow and perceived as a formality in the process.610 Other Commissioners disagreed with this characterization of the process, but acknowledged the benefit to all parties of a more effective and efficient process. The Commissioners then analyzed improving the current framework under section 1113. They recognized the delicate balance between encouraging meaningful negotiations and allowing the debtor in possession to move to litigation when necessary. To evaluate potential reforms to the section  1113 process, the Commissioners reviewed practices that have been employed in many chapter 11 cases, in which the parties opted for case management procedures in lieu of the statutory scheduling requirements, and have identified certain “best practices” from these cases. Their discussion focused on the realities of chapter 11 practice — as suggested by Professor Dawson’s study, the debtor in possession usually can prevail on the motion to reject, but that result typically is not in the best interests of the debtor or its employees. Rather, a consensual resolution typically is in the best interests of both parties; it can avoid potential ill will between the parties, lost production for the debtor, and hardship for its employees. The Commissioners proposed a more structured process for exchanging information and establishing the parameters of bargaining. The Commissioners debated whether the court should be involved in the process from the outset. The Commission determined that requiring an initial status conference with the court would encourage meaningful disclosures and discussions earlier in the process. In 6 this context, it also considered the mandatory appointment of a mediator 201help the parties reach 1, to ber 2 vem a potential resolution more quickly. The Commissioners perceived value in the mediator’s role, but n No ed o rchiv expressed concerns regarding costs and a one-size-fits-all approach to a mediator. They believed that 63 a -353 a mediator likely would be an asset in No. 14 cases, but believed it would be a more effective tool if , many rown v. Bparticular case.611 invoked based on the facts eth the of xs i in Bl cited Under the principles adopted by the Commission, there would be an initial conference that would follow disclosure of the proposal by the debtor in possession to the authorized representative and a notice to parties in the case of the debtor in possession’s intention to seek modifications to a collective bargaining agreement by commencing a section 1113 process. The Commission determined that, at an initial conference with the court, the parties should discuss their bargaining timeline, any issues regarding disclosures made by the debtor in possession regarding its proposal, and any potential barriers to meaningful, good faith negotiations. It did not believe that the statute should establish specific deadlines for negotiations. Instead, it wanted the parties and the court to have flexibility under the general guidance that the bargaining parties have reasonable time to engage in meaningful, good-faith negotiations. 610 Oral Testimony of Robert Roach, Jr.: ACB Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 58 (Mar. 14, 2013) (ASM Transcript), available at Commission website, supra note 55; Oral Testimony of Debora Sutor: ACB Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 42–45 (Mar. 14, 2013) (ASM Transcript), available at Commission website, supra note 55; Oral Testimony of James Campbell Little: ACB Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 35 (Mar. 14, 2013) (ASM Transcript), available at Commission website, supra note 55. 611 Oral Testimony of Robert Roach, Jr.: ACB Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 60 (Mar. 14, 2013) (ASM Transcript) (stating that whether a mediator would be helpful depends on the circumstances of the case), available at Commission website, supra note 55; Oral Testimony of James Campbell Little, Jr.: ACB Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 60 (Mar. 14, 2013) (ASM Transcript) (noting that mediators are not a panacea and that the utility of a mediator will vary by case, by mediator, etc.), available at Commission website, supra note 55. V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 170 of 402 Bankruptcy Institute The Commissioners also discussed an appropriate trigger for permitting a debtor in possession to proceed to litigation to reject the agreement. They compared a trigger similar to one proposed by labor-backed legislation (i.e., the NLRA standard), based upon standards under nonbankruptcy labor law requiring an employer to bargain to “impasse” prior to unilateral implementation,612 and the alternative of imposing an outside deadline based only on the passage of time. Although the Commissioners understood labor’s preference for the NLRA standard, many of the Commissioners believed that the debtor in possession needed certainty as to when the case could move forward if a consensual resolution was not forthcoming. These Commissioners noted that the impasse standard could stall a debtor in possession’s restructuring efforts indefinitely to the detriment of the debtor in possession and its other stakeholders (and arguably the employees as well). After considering various triggers, the Commission voted to recommend that the procedures incorporate an outside date for the start of the trial on the debtor in possession’s motion to reject within 180 days of the debtor in possession’s request for an initial conference. The Commissioners noted specifically that the forgoing recommended principles regarding the new case management procedures applied only when a debtor in possession pursued relief under section 1113(b), (c), or (d), and that the principles were not intended to change the current law under section 1113(e) applicable to a debtor in possession’s request for interim, emergency relief. In developing the principles for the enhanced case management process, the Commission also considered whether and to what extent other parties in interest should participate in the section 16 1113 proceedings.613 For example, some of the Commissioners suggestedber 21a 20 that , statutory unsecured m creditors’ committee should be permitted to participate in dthe Nove n process. Others noted that the e o iv committee is not a party to the agreement and raised63 arch about introducing third parties into concerns -353 4 the negotiation process.614 The Commission o. 1 , Nsettled on the approach used in the Delphi chapter 11 rown h case, where, in ruling on a motion v. Blimit participation in the section 1113 proceedings, the court xset to n Bli ed iparties, including the statutory unsecured creditors’ committee, could determined that certain cit participate in the section 1113 process solely with respect to asserting a position regarding the debtor in possession’s business judgment in seeking section 1113 relief and not with respect to whether the section 1113 factors had been met.615 The Commission found persuasive the Delphi court’s distinction between the role of the statutory committee in fulfilling its due diligence obligations regarding the debtor in possession’s business judgment to pursue the rejection motion, as a non-ordinary course action by the debtor in possession, and the particulars of the bargaining process and related section 1113 factors, which are matters that should be left to the debtor in possession and the authorized representative both in terms of their negotiations and litigation regarding the debtor in possession’s proposal and related bargaining. 612 See The Protecting Employees and Retirees in Business Bankruptcies Act of 2013, H.R. 100, 113th Cong. § 102 (1st sess. 2013) (proposing that a debtor may file a motion to reject a collective bargaining agreement, if, after a period of negotiations, the debtor and labor representative have not reached agreement on modifications “and further negotiations are not likely to produce mutually satisfactory modifications”). See also N.L.R.B. v. Bildisco & Bildisco, 465 U.S. 513, 533 (1984) (describing “impasse” requirement under the NLRA). 613 See 11 U.S.C. § 1113(d)(1) (providing that, at a hearing on the motion to reject a collective bargaining agreement, “[a]ll interested parties may appear and be heard at such hearing”). The Seventh Circuit has held that section 1113(d)(2) limits the participants— the parties who are authorized to modify the agreement (and any guarantor of the agreement) — to the debtor and the applicable bargaining representative(s) of the affected employees. In re UAL Corp., 408 F.3d 847 (7th Cir. 2005). 614 See, e.g., Oral Testimony of David R. Jury: ACB Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 23 (Mar. 14, 2013) (ASM Transcript) (“Collective bargaining is a relationship that in most cases long predated the filing of the petition and if the parties are successful will continue long after the bankruptcy case closes. On the other hand, creditor’s committees [are transient]. It came into existence with the case, it will go out of existence with the end of the case.”), available at Commission website, supra note 55. 615 In re Delphi Corp., Case No. 05-44481 (Bankr. S.D.N.Y. May 9, 2006) (oral decision).  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 171 of 402 ABI Commission to Study the Reform of Chapter  The Commission also considered the consequences of the rejection of a collective bargaining agreement; specifically, does rejection give rise to a rejection damages claim, and if so, how should the claim be determined? The Commissioners discussed the current split in the case law regarding rejection damages under section 1113. One court decision, In re Blue Diamond Coal Co., held that rejection damages were unavailable under section 1113 as a matter of statutory construction.616 The Blue Diamond court’s view was that section 1113 completely removed collective bargaining agreements from the provisions of section 365 of the Bankruptcy Code.617 Other courts have disagreed with the Blue Diamond analysis of section 1113 and its relationship to section 365 and other provisions of the Bankruptcy Code, and instead have interpreted sections 1113 and 365 as working in tandem, thus permitting the assertion of rejection damages claims for the rejection of collective bargaining agreements under section 1113. As one court has explained, “[s]ection 1113 is designed to provide additional procedural requirements for rejection or modification of collective bargaining agreements, and only to that degree supersedes and supplements the provisions in § 365.”618 The Commissioners also noted the discussion by the court in Northwest Airlines.619 In this decision, the court labeled the effect of rejection as an “abrogation” of the agreement rather than a breach of the agreement, thus calling into question whether an order granting rejection could give rise to a claim for rejection damages. The Commissioners were persuaded by the reasoning and results of courts interpreting section 1113 as supplementary to section 365, as well as the practicalities 16 1, 0 of the availability of a rejection damages claim in reaching a resolution. 2The Commission voted ber 2 m to recommend that section 1113 be amended to clarifyd that ove n N rejection of a collective bargaining e o hiv agreement constitutes a breach of the agreement3asrcof the time of rejection, and that a claim for 6 a -353 . 14 rejection damages may be asserted. TheoCommissioners also discussed how such claims would be ,N rown B h v. determined. First, the Commission determined that, like damages claims asserted by nondebtor xset n Bli parties to contracts irejected under section 365, such claims would be general unsecured claims cited where rejection occurs prior to assumption of a collective bargaining agreement.620 In addition, the Commission agreed that, generally, such claims would be based on the difference between the reductions implemented following rejection and the collective bargaining agreement terms prior to rejection, akin to a breach of contract claim under federal labor law, noting specifically that to the extent actual mitigation of damages by particular employees would apply to such claims, such mitigation would similarly apply to a rejection damages claim.621 616 In re Blue Diamond Coal Co., 147 B.R. 720 (Bankr. E.D. Tenn. 1992), aff ’d, 160 B.R. 574 (E.D. Tenn. 1993). 617 See Michael St. Patrick Baxter, Is There a Claim For Damages from the Rejection of a Collective Bargaining Agreement Under Section 1113 of the Bankruptcy Code?, 12 Bankr. Dev. J. 703 (1996) (reviewing Blue Diamond decision). 618 Mass. Air Conditioning & Heating Corp. v. McCoy, 196 B.R. 659, 663 (D. Mass. 1996) (citing Norfolk and Western Railway Co. v. Am. Train Dispatchers Ass’n, 499 U.S. 117, 136 n. 2 (1991) (Stevens, J., dissenting)). See also In re Moline Corp., 144 B.R. 75, 78 (Bankr. N.D. Ill. 1992) (ruling that section 365 operates to fill in the gap left in section 1113 regarding rejection damages and that such omission was a legislative error); Baxter, supra note 617 (concluding that section 365 continues to apply except to the extent inconsistent with section 1113 and that section 365(g) applies to permit a claim for rejection damages). 619 Nw. Airlines Corp. v. Ass’n of Flight Attendants (In re Nw. Airlines Corp.), 483 F.3d 160 (2d Cir. 2007). 620 The allocation of a rejection damages among affected employees generally is handled in the context of the proof of claim filed by the authorized representative, but different procedures have been applied depending on the circumstances.  See In re U.S. Truck Co., Inc., 89 B.R. 618 (E.D. Mich. 1988) (basing allocation on union’s proof of claim). The Commission’s recommendation on rejection damages under section 1113 does not affect these various approaches to allocation. 621 See id. at 625 (overruling objections to union claim for rejection damages and, where employer based need for rejection on ability to continue operation of the business, allowing union’s claim to be calculated as the difference between reductions in compensatory terms and other monetary terms implemented post-rejection and terms under nonrejected collective bargaining agreement, based on analogy to claim under federal labor law for unilateral breach of collective bargaining agreement). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 172 of 402 Bankruptcy Institute 2. Retiree Benefits and Section 1114 Recommended Principles: The trustee should comply with the requirements of section 1114 of the Bankruptcy Code for all retiree benefits (as defined in section  1114(a)), even if the trustee contends that such benefits are terminable at will under the terms of the benefit plan or applicable nonbankruptcy law. The trustee’s compliance with section 1114 for benefits that the trustee contends may be terminable at will should not create any new claims on behalf of retirees or otherwise affect the existence, nature, or scope of any retirees’ claims upon the termination or modification of such benefits in accordance with section 1114, which claims should be determined consistent with the terms of the plan or applicable nonbankruptcy law. Retiree Benefits and Section 1114: Background Section 1114 requires the debtor in possession622 to timely pay any retiree benefits and to follow a notice, disclosure, and bargaining process before seeking to modify any retiree benefits during the chapter 11 case. It also provides administrative priority for payments of retiree benefits required to 16 be made before the effective date of a confirmed plan.623 The protections rafforded retiree benefits 1, 20 be 2 m under section 1114 are supplemented by a corresponding plannconfirmation requirement under Nove ed o v section  1129(a)(13). Section  1114 defines the term363 archi benefits” as “payments to any entity “retiree -35 or person for the purpose of providing or No. 14 , reimbursing payments for retired employees and their own v. Brsurgical, or hospital care benefits, or benefits in the event of spouses and dependents, for imedical, eth Bl xs ed in or death under any plan, fund, or program (through the purchase of sickness, accident, disability, cit insurance or otherwise) maintained or established in whole or in part by the debtor prior to filing a petition commencing a case under this title.”624 With respect to the modification of retiree benefits, the section 1114 process resembles the section 1113 process for the rejection of collective bargaining agreements, with at least one key difference.625 Under section 1114, a committee authorized by the court to serve as an “authorized representative” of such retirees will represent retirees who are receiving benefits not covered by a collective bargaining agreement in the section 1114 process.626 As suggested above, the term “retiree benefits” is broad and covers such payments under any prepetition “plan, fund, or program (through the purchase of insurance or otherwise) maintained or established” by the debtor. In fact, some courts interpret this language to include payments under a prepetition retiree benefit plan even if the debtor contends that it has expressly reserved the right 622 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. 623 11 U.S.C. § 1114(e). 624 11 U.S.C. § 1114(a). 625 See In re Farmland Indus., Inc., 294 B.R. 903, 918 (Bankr. W.D. Mo. 2003) (“A consideration of § 1113 of the [Bankruptcy] Code provides further support for the Court’s understanding of § 1114.”). 626 11 U.S.C. § 1114(b)(1), (2), (d). The union under the collective bargaining agreement that gave rise to the retiree benefits presumptively serves as the authorized representative for retirees receiving such benefits. 11 U.S.C. § 1114(c).  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 173 of 402 ABI Commission to Study the Reform of Chapter  to unilaterally terminate or modify such plan at any time. 627 For example, in Visteon, the relevant plan documents provided that “the Company reserves the right to suspend, modify or amend the benefits provided under the Plan, or even terminate the Plan or any of the benefits provided under the Plan. . . . [T]his handbook is not a contract, nor is it a guarantee of your coverage.”628 The Third Circuit adopted a strict reading of the statute and determined that “[t]he fact that the debtor could have unilaterally stopped the payments had it not been in chapter 11 is . . . irrelevant.”629 Nevertheless, other courts have ruled that a debtor in possession is not required to comply with the section 1114 process when the debtor in possession establishes that it has the right under the prepetition program of benefits to unilaterally modify or terminate the benefits.630 Retiree Benefits and Section 1114: Recommendations and Findings Bankruptcy Code sections 1114 and 1129(a)(13) evidence a strong policy preference for protecting the rights of retirees in a debtor in possession’s chapter 11 case. Section 1114 was enacted in response to the LTV Steel Company chapter 11 case in which the debtor in possession announced its intention to discontinue health benefits for approximately 70,000 retired employees immediately upon the petition date on the basis that such benefits would be considered prepetition claims.631 The Commissioners understood the history behind section 1114 and the special protections afforded retirees under the Bankruptcy Code. They also observed that retiree issues, when present in a chapter 11 case, can create complex and challenging issues for the debtor in possession. 16 , 20 er 21 emb The Commissioners discussed the current split in the case on Nov law regarding whether the section 1114 ived arch procedures apply to all prepetition retiree benefit plans, including those that were found to be 5363 14-3 No. bankruptcy. The Commissioners acknowledged the plain terminable at will by the debtor outside of n, Brow meaning interpretation lofseth v. 1114 endorsed by the Third Circuit in Visteon. They discussed section ix in B ited the focus of thiscdecision on the application of section 1114 during the pendency of the chapter 11 case. As the Third Circuit explained in discussing the treatment of retiree benefits under a chapter 11 plan, “the duration of the period the debtor has obligated itself to provide such benefits plainly encompasses any durational obligations, including those arising outside of the bankruptcy context.”632 Accordingly, even if bound by the section 1114 process during the chapter 11 case, the reorganized 627 See, e.g., IUE-CWA v. Visteon Corp. (In re Visteon Corp.), 612 F.3d 210, 219–20 (3d Cir. 2010) (“Section 1114 could hardly be any clearer. It restricts a debtor’s ability to modify any payments to any entity or person under any plan, fund, or program in existence when the debtor files for Chapter 11 bankruptcy, and it does so notwithstanding any other provision of the [B] ankruptcy [C]ode.”); In re Farmland Indus., Inc., 294 B.R. 903, 914 (Bankr. W.D. Mo. 2003) (“In this court’s view, §1114 prohibits a debtor from terminating or modifying any retiree benefits (as defined in that section) during a Chapter 11 case unless the debtor complies with the procedures and requirements of §1114, regardless of whether the debtor has a right to unilaterally terminate benefits.”). See also IUE-CWA v. Visteon Corp. (In re Visteon Corp.), 612 F.3d 210, 227 (3d Cir. 2010) (explaining legislative history indicating a desire to protect “the ‘legitimate expectations’ of retirees, and the necessity in a ‘just society’ of giving effect to those expectations wherever possible”); S. Rep. No. 100-119, at 1–2 (1987), reprinted in 1988 U.S.C.C.A.N. 683, 684 (“[T]o provide additional protections for the insurance benefits of retirees, their spouses and dependents, of debtors under the Bankruptcy Code”). 628 IUE-CWA v. Visteon Corp. (In re Visteon Corp.), 612 F.3d 210, 213 (3d Cir. 2010). 629 Id. at 222. 630 See, e.g., In re Gen. Motors Corp., No. 09-50026, Hr’g Tr. at 109:24-110:2 (Bankr. S.D.N.Y. June 25, 2009) (“Section 1114 doesn’t apply to employee benefit plans that are terminable or amendable unilaterally by the plan sponsor.”); In re Delphi Corp., 2009 WL 637259, at *19 (S.D.N.Y. Mar. 11, 2009) (“[I]f, in fact, the debtors have the unilateral right to modify a health or welfare plan . . . the debtors’ pre-Bankruptcy rights [are not] abrogated by the requirements of section 1114.”); In re N. Am. Royalties, Inc., 276 B.R. 860 (Bankr. E.D. Tenn. 2002); Retired W. Union Employees Ass’n v. New Valley Corp. (In re New Valley Corp.), 1993 WL 818245 (D.N.J. Jan. 28, 1993); In re Doskocil Cos. Inc., 130 B.R. 870 (Bankr. D. Kan. 1991). 631 See In re Chateaugay Corp., 64 B.R. 990, 992 (S.D.N.Y. 1986); 133 Cong. Rec. H8558 (daily ed. Oct. 13, 1987) (“[T]he triggering event for [enacting § 1114] was [the] bankruptcy of LTV Steel. . . .”). 632 IUE-CWA v. Visteon Corp. (In re Visteon Corp.), 612 F.3d 210, 224 (3d Cir. 2010) (citations omitted) (internal quotation marks omitted). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 174 of 402 Bankruptcy Institute debtor could exercise any applicable contractual or nonbankruptcy law rights after the bankruptcy. The Commissioners also noted certain procedural advantages provided by the statute, including the designation of a statutory authorized representative for retirees to engage in the process. The Commissioners weighed the Visteon approach against several competing considerations. For example, courts finding that certain retiree benefit plans fall outside the scope of section 1114 and rely heavily on the parties’ prepetition nonbankruptcy rights. Some commentators have noted the practical appeal to this approach given that, even under Visteon, the debtor in possession presumably could pay retiree benefits during the case and then, as a reorganized debtor, terminate or modify those benefits immediately after the case, provided that the prepetition benefit plan was found to support a reservation of that right for the company as plan sponsor. The Commissioners also factored into their deliberations the significant complexity of conducting “at will” litigation over the scope of section 1114 during bankruptcy and the time and expense consumed by such litigation. They evaluated the utility of this litigation to the chapter 11 case. The Commissioners generally found nominal value in the litigation because section 1114 is a processbased provision. Any such changes could occur only if the parties agreed to them through the section 1114 negotiation process or the court authorized the modifications proposed by the debtor in possession after the required negotiations. 1 Moreover, the Commissioners discussed the purpose and value of the process 6itself. The steps 1, 20 ber 2 required by section 1114 provide retirees with representation on Noa eseat at the negotiation table and v m ed rchiv during the chapter 11 case. The process not only gives retirees a voice, but it also ensures that any 63 a -353 changes proposed or made by the debtor ,in o. 14 N possession to retiree benefits are not precipitous and own rThe Commissioners found value in the process for both the are understood by all affected seth v. B parties. x n Bli debtor in possession cand iretirees in cases in which the debtor in possession believed some change ited to retiree benefits was necessary — regardless of whether the debtor could implement such change unilaterally outside of bankruptcy. In light of the various relevant factors, the Commission determined that requiring a debtor in possession to follow the section 1114 process for any proposed change to, or termination of, any retiree benefits was the better approach. In reaching this conclusion, however, the Commission also agreed that the debtor in possession’s initiation of the section 1114 process where the debtor could have asserted a unilateral right to modify or terminate outside of bankruptcy should not create new claims or otherwise change the claims currently provided under the statute. Accordingly, if the parties agreed to, or the court approved, a change to, or termination of, retiree benefits through the section 1114 process, a debtor in possession asserting an “at will” or other defense limiting its obligations under the prepetition plan could assert such defense in objecting to the amount of any claims asserted by the retirees or their authorized representative arising from the termination or modification of the benefit plan through the section 1114 process. Likewise, the respective rights and remedies of the reorganized debtor and retirees under the prepetition plan (unless such obligations were altered by agreement as part of the 1114 negotiation process) would continue following the debtor’s emergence from chapter 11.  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 175 of 402 ABI Commission to Study the Reform of Chapter  E. Administrative Claims 1. Section 503(b)(9) and Reclamation Recommended Principles: The protections afforded by section 503(b)(9) of the Bankruptcy Code should be limited to the value of goods received by, or at the direction of, the debtor in the ordinary course of business within 20 days before the commencement of the case. Section 503(b)(9) should be amended accordingly to permit creditors providing goods on a drop shipment basis to assert appropriate claims under this section. A creditor should be required to file a proof of claim and appropriate supporting documentation for any claims it may hold against the estate under section 503(b) (9) on or before the applicable bar date unless otherwise provided by an order of the court. Any such proof of claim should specifically identify the amount of the claim that the creditor asserts is subject to section 503(b)(9). A creditor’s failure to file a timely proof of claim should constitute a waiver of such claim unless otherwise provided by an order of the court. 16 , 20 er 21 emb rights or remedies that A party’s rights under section 503(b)(9) should replacevany No d on chive the party may have under applicable nonbankruptcy law based upon reclamation ar 5363 . 14section 546(c) should be amended accordingly. or similar doctrines. Accordingly, -3 , No own v. Br eth Blixs ed in cit Section 503(b)(9) and Reclamation: Background Section 503(b)(9) of the Bankruptcy Code provides administrative claim treatment to trade creditors for “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 business.”633 The BAPCPA Amendments added this section to the Bankruptcy Code. “The legislative history surrounding this section is scant, but presumably Congress was concerned about providing a vehicle to enhance payment to creditors who shipped goods to a debtor in the ordinary course of business on the eve of bankruptcy.”634 Under section 503(b)(9), trade creditors selling goods (but not providing services) to the debtor during the immediate prepetition period receive an administrative priority claim for the value of those goods that remains unpaid on the petition date, regardless of whether the seller satisfies the requirements for reclamation. Prior to the BAPCPA Amendments, the entirety of a trade creditor’s claims were treated as general unsecured claims, unless such creditor could establish a valid reclamation claim under Section 2-702 of the Uniform Commercial Code and section 546 of the 633 11 U.S.C. § 503(b)(9). 634 Judith Greenstone Miller & Jay L. Welford, 503(b)(9) Claimants — The New Constituent, a/k/a “The 500 Pound Gorilla,” At The Table, 5 Depaul Bus. & Com. 487 (2007). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 176 of 402 Bankruptcy Institute Bankruptcy Code. To establish a reclamation claim, a creditor was required to, among other things, send its reclamation demand within 10 days after the buyer received the goods. The BAPCPA Amendments implemented two key changes. First, they elevated certain of a trade creditor’s claims to administrative priority under section 503(b)(9). Second, they extended the reclamation reachback period to 45 days and, if the 45-day period had not expired when the bankruptcy petition was filed, granted the creditor an additional 20 days from the commencement of the bankruptcy case to send its written reclamation demand. Although the second change appeared favorable to trade creditors in theory, it has turned out, in practice, to be often illusory. Section 546(c) also states that reclamation rights are expressly subject to the prior rights of a creditor with a security interest in the goods, largely reaffirming prior case law.635 Accordingly, as a practical matter, trade creditors seek to protect a portion of their prepetition claims under section 503(b)(9) and rarely pursue their reclamation rights under state law and section 546(c). One issue that frequently arises in this context is the process trade creditors must follow to preserve their administrative claim under section 503(b)(9). Section 503(b) states that allowance of a claim under that section is subject to notice and a hearing. This may require a creditor asserting a section 503(b)(9) claim to retain counsel and to file a motion because there is no Bankruptcy Code provision or Bankruptcy Rule permitting creditors to assert their section 503(b)(9) claims by filing a proof of claim. In certain cases, in order to simplify the process of asserting section 503(b) 6 (9) claims and to minimize the costs of addressing those claims, debtors er 21, 201 have moved for approval b of, and courts have approved, procedures that have either authorized vem modification of the official No the d on chive reference to section 503(b)(9) claims proof of claim form (the “Official Form”) to include3a 3 ar specific 35 6 . 14- to assert the section 503(b)(9) claim. or authorized the filing of a separate proof ,of o n N claim h v. xset n Bli i Brow Although section 503(b)(9) has provided additional protections to trade creditors who supply goods cited to the debtor, certain aspects of section 503(b)(9) are ambiguous. The ambiguities include: (i) what constitutes “goods,”636 (ii) how is the “value” of goods determined,637 (iii)  when goods have been “received,”638 (iv) whether section 503(b)(9) claims should be disallowed or be subject to setoff when a preference or other claim is asserted against the subject creditor,639 and (v) when should section 635 See, e.g., In re Furrs Supermarkets, Inc., 2012 WL 3396146, at * 3 (Bankr. D.N.M. 2012); In re Circuit City Stores, Inc., 441 B.R. 496, 508–10 (Bankr. E.D. Va. 2010); In re Advanced Marketing Servs., Inc., 360 B.R. 421, 427 (Bankr. D. Del. 2007); In re Dana Corp., 367 B.R. 409, 419 (Bankr. S.D.N.Y. 2007). 636 In re NE Opco, Inc., 2013 WL 5880660 (Bankr. D. Del. Nov. 1, 2013) (holding that electricity provided by municipal lighting plant was a service not a good, but natural gas provided by the same plant was a good); In re S. Mont. Elec. Generation & Transmission Coop., Inc., 2013 WL 85162 (Bankr. D. Mont. Jan. 8, 2013) (holding that electricity was a good where debtor was not an end user, but only a wholesaler of electricity); GFI Wis., Inc. v. Reedsburg Util. Comm’n, 440 B.R. 791 (W.D. Wis. 2010) (holding that electricity is a good where debtor was not an end user of electricity); In re Erving Indus., Inc., 432 B.R. 354 (Bankr. D. Mass. 2010) (holding that electricity is a good, not a service); In re Plastech Engineered Prods., Inc., 397 B.R. 828 (Bankr. E.D. Mich. 2008) (natural gas is a good). But cf. In re Pilgrim’s Pride Corp., 421 B.R. 231 (Bankr. N.D. Tex. 2009) (holding that natural gas and water are goods subject to section 503(b)(9), but where debtor is the end user of electricity, electricity is not a good but rather a service, and thus is not subject to section 503(b)(9)); In re Samaritan Alliance, LLC, 2008 WL 2520107 (Bankr. E.D. Ky. June 20, 2008) (holding that electricity is better characterized as a service, not a good). 637 In re S. Mont. Elec. Generation & Transmission Coop., Inc., 2013 WL 85162 (Bankr. D. Mont. 2013) (holding that invoice price is proper value of goods); In re SemCrude, L.P., 416 B.R. 399 (Bankr. D. Del. 2009) (same); In re Pilgrim’s Pride Corp., 421 B.R. 231 (Bankr. N.D. Tex. 2009) (holding that replacement cost is the proper value of goods). 638 In re Momenta, Inc., 455 B.R. 353 (Bankr. D.N.H. 2011) (addressing whether drop shipped goods were received by the debtor); In re Circuit City Stores, Inc., 432 B.R. 225 (Bankr. E.D. Va. 2010) (addressing when consigned goods were received by the debtor); In re Plastech Engineered Prods., Inc., 397 B.R. 828 (Bankr. E.D. Mich. 2008) (addressing whether drop shipped good were received by the debtor). 639 In re Ames Dep’t Stores, Inc., 582 F.3d 422 (2d Cir. 2009) (holding that section 502(d) is not a ground for disallowance of an administrative priority claim); In re Energy Conversion Devices, Inc., 486 B.R. 872 (Bankr. E.D. Mich. 2013) (same); In re Plastech Engineered Prods., Inc., 394 B.R. 147 (Bankr. E.D. Mich. 2008) (same). See also In re Momenta, Inc., 455 B.R. 353 (Bankr. D.N.H. 2011) (holding that section 502(d) is not a ground for disallowance of a section 503(b)(9) claim); In re TI  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 177 of 402 ABI Commission to Study the Reform of Chapter  503(b)(9) claims be paid (on the effective date or sometime earlier).640 Both creditors and the estate are affected by these issues and frequently incur litigation costs to try to resolve the uncertainty. Section 503(b)(9) and Reclamation: Recommendations and Findings The Commission received conflicting testimony concerning the administrative priority of trade claims for certain goods under section 503(b)(9). Some witnesses testified that this additional class of administrative claims made it more difficult for debtors to reorganize because the chapter 11 plan must pay these claim in full on the effective date under section 1129(a)(9).641 This testimony was consistent with testimony provided to Congress on the topic of the Circuit City bankruptcy and similar retail chapter 11 cases.642 Other witnesses strongly disputed that trade claims were an impediment to confirmable plans of reorganization.643 The Commissioners weighed this testimony with anecdotal evidence concerning the types of challenges faced by chapter 11 debtors, including retail debtors, since 2005.644 For example, debtors are more highly leveraged.645 As a result, they have less value available to support their reorganization efforts. The economic recession that started in 2008 affected several industries and accelerated or contributed to firms’ financial distress. The BAPCPA Amendments also made other changes to the Bankruptcy Code that arguably altered chapter 11 practice, at least as compared to the pre-2005 period.646 6 1 1, 20 ber 2 m Nove d n eIn o MicroAge, Inc., 291 B.R. 503 (B.A.P. 9th Cir. 2002) Acquisition, LLC, 410 B.R. 742, (Bankr. N.D. Ga. 2009) (same).aBut icf. re rch v 63 (holding that debtor could assert preference claim as4basis for temporarily disallowing section 503(b)(9) priority claims); In re -353 o 1 Circuit City Stores, Inc., 426 B.R. 560 (Bankr.,E.D..Va. 2010) (same). n N 640 In re Arts Dairy, LLC, 414 B.R. 219 . Brow N.D. Ohio 2009) (explaining that a debtor was not immediately required to pay a (Bankr. hv section 503(b)(9) claim); InliresGlobal Home Prods., LLC, 2006 WL 3791955 (Bankr. D. Del. Dec. 21, 2006) (holding that section x et n B after confirmation of plan); In re Bookbinders’ Rest., Inc., 2006 WL 3858020 (Bankr. E.D. Pa. Dec. 503(b)(9) claim shouldi be paid cited 28, 2006) (holding that claimant was not entitled to immediate payment of section 503(b)(9) claim). 641 Written Statement of John Collen, Partner, Tressler LLP: NCBJ Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 2–3 (Apr. 26, 2012) (stating that section 503(b)(9) puts huge demands on the cash of the debtor and undermines the debtor’s reorganization), available at Commission website, supra note 55; Written Statement of Dan Dooley, CEO of MorrisAnderson: ASM Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (Apr. 19, 2013) (stating that section 503(b)(9) increases the cost of reorganization which in turn fuels trend toward bankruptcy alternatives), available at Commission website, supra note 55; First Report of the Commercial Fin. Ass’n to the ABI Comm’n to Study the Reform of Chapter 11: Field Hearing at Commercial Fin. Ass’n Annual Meeting, at 10 (Nov. 15, 2012) (“Because holders of administrative claims are not placed in classes and do not vote on a plan, and each administrative creditor must be paid in full in cash at the time of confirmation, unless that creditor agrees otherwise, §503(b)(9) creates holdout power in all members of a particular group of creditors, contrary to the policy of bankruptcy law to reduce such power. Because of that power, and the requirement to pay all administrative expenses even in sale cases, secured creditors will reserve for such claims, reducing the resources available to distressed debtors for reorganization.”) (citations omitted), available at Commission website, supra note 55. 642 See Circuit City Unplugged: Why Did Chapter 11 Fail to Save 34,000 Jobs?: Hearing Before the Subcomm. on Commercial and Administrative Law of the Comm. on the Judiciary, 111th Cong. 44 (2009) (statements of Harvey R. Miller and Richard M. Pachulski). But see id. (statement of Professor Todd J. Zywicki, George Mason School of Law) [hereinafter Zywicki Statement]; Lehman Brothers, Sharper Image, Bennigan’s and Beyond: Is Chapter 11 Bankruptcy Working?: Hearing Before the Subcomm. on Commercial and Administrative Law of the Comm. on the Judiciary, 110th Cong. 21 (2008) (statement of Professor Barry E. Adler, Esq., New York University School of Law) [hereinafter Adler Statement]. 643 See generally Transcript, NACM Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (May 21, 2013), available at Commission website, supra note 55. 644 See, e.g., Bob Duffy, Broken Beyond Repair: Is BAPCPA Unfairly Blamed for Rash Retail Liquidations, J. of Corp. Renewal (Jan. 8, 2009); Written Statement of Lawrence Gottlieb, Partner, Cooley LLP: NYIC Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 3 (June 4, 2013) (stating that BAPCPA deadlines are hurting retail debtors’ chances of rehabilitation), available at Commission website, supra note 55 645 See U.S. Retail Case Studies in Bankruptcy Enterprise Values and Creditor Recoveries, Fitch Case Studies — Retail Edition 1–2 (Apr. 16, 2013) [hereinafter Fitch Report] (observing that there is a “tendency of distressed retailers to maximize secured borrowings, subordination of significant administrative claims and dilution of recoveries from pension, general unsecured trade and operating lease rejection claims placed downward pressure on unsecured recoveries”) Analyzing a sample of 20 retail cases, the Fitch Report observed that in each case at least one first lien claim was paid in full, but, alternatively, the median unsecured claim recovery was less than 10 percent, while the average was 20 percent. Id. See also Stephen A. Donato & Thomas L. Kennedy, Trends in DIP Financing: Not as Bad as It Seems?, J. Corp. Renewal, Sept./Oct. 2009. 646 See Section III.A, Brief History of U.S. Business Reorganization Laws. V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 178 of 402 Bankruptcy Institute The Commissioners acknowledged that trade creditors are aware of, and rely on, their rights under section 503(b)(9) in making prepetition credit and shipment decisions. Some of the Commissioners raised concerns about the increasing number of administrative and priority claims categories.647 Each additional administrative or priority claim category undercuts the Bankruptcy Code’s policy of fair and pro rata distributions among similarly situated creditors. The Commission agreed that administrative and priority status should be a limited exception and that general unsecured status should be the rule. Several Commissioners did not believe, however, that eliminating the section 503(b)(9) category would provide significant benefits to the estate, but they did believe that it may make operating the debtor’s prepetition business more challenging or expensive to the extent that trade creditors refuse to ship goods or will do so only on modified credit or all-cash terms. On balance, the Commission voted to retain the section 503(b)(9) administrative claims priority, provided that this provision represent the only priority treatment made available to such creditors. The Commission also agreed to recommend the elimination of all reclamation rights in bankruptcy under section 546(c), as well as any doctrine of necessity arguments related to these claims.648 In making this determination, the Commissioners discussed whether a valid basis existed for excluding drop shipment transactions, when the trade creditor supplies goods on the debtor’s behalf to another party, from section 503(b)(9). The Commissioners acknowledged the statutory support for the exclusion given that the debtor does not “receive” the goods in this instance and given that 16 1, 2 Nevertheless, they section 503(b)(9) was intended to benefit creditors with reclamation rights.649 0 ber 2 m No to discussed the substance of drop shipment transactions and theirnuseve increase efficiencies in the ed o iv transactions, which may still be provided for the benefitrch the debtor’s business. Accordingly, the 63 a of -353 14 Commission determined that, if the debtor, directed the creditor to ship the goods directly to a third No. rown party in lieu of the debtor making v. B shipment, then applying section 503(b)(9) serves the same eth that Blixs ed in trade creditors to supply goods on credit and should apply to the drop policy goal of encouraging cit shipment transaction. The Commissioners also discussed the inclusion of services in section 503(b)(9). Again, the Commissioners recognized the difficulty in drawing a bright line to limit the scope of the exception to that necessary to achieve the desired policy goals. They distinguished service providers from suppliers of goods based on their respective state law rights and the use of section 503(b)(9) as a substitution for creditors’ state law reclamation rights. They also believed that a debtor in possession would have adequate ability to justify and request authority to pay service providers critical to the business and reorganization efforts through the Commission’s proposed codification of the doctrine of necessity, as explained above.650 The Commissioners did note the confusion and uncertainty regarding the process for creditors to assert and preserve section 503(b)(9) claims. Some of the Commissioners suggested that, just as with any other administrative claim request, the creditor should be required to file a motion and justify the request. Other Commissioners believed that such a requirement would add unnecessary 647 See, e.g., Howard Delivery Serv. Inc. v. Zurich Am. Insur. Co., 547 U.S. 651, 655 (2006) (explaining that exceptions to general equality principle should be “clearly authorized by Congress” and strictly construed). 648 See Section IV.D.1, Prepetition Claims and the Doctrine of Necessity. 649 See, e.g., Ningbo Chenglu Paper Prods. Mrf. Co., Ltd v. Momenta, Inc. (In re Momenta, Inc.), 2012 WL 3765171, at *4 (D.N.H. Aug. 29, 2012). 650 See Section IV.D.1, Prepetition Claims and the Doctrine of Necessity.  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 179 of 402 ABI Commission to Study the Reform of Chapter  cost to the process and would not be particularly efficient for either the debtor in possession or the estate in many cases. After discussing various alternatives, the Commission agreed that these principles should recommend a modification to section 503(b)(9), the Bankruptcy Rules, and the Official Form to require creditors asserting section 503(b)(9) claims to file a proof of claim for such claims on or before the general bar date or a specific section 503(b)(9) bar date established by the court. 2. Administrative Claims Committee Recommended Principles: Neither the court nor the U.S. Trustee should be authorized to constitute an official committee of administrative claimants. Accordingly, a new provision should be added to section 1102 to clarify this point. Administrative Claims Committee: Background Section 1102 of the Bankruptcy Code currently mandates the appointment of a committee of creditors holding unsecured claims and allows the court to order the appointment 016other committees of of 2 r 21, creditors or equity security holders “if necessary to assure adequatembe representation” of such creditors ove on Ncommittee are vetted and appointed or equity security holders. In all instances, the members ed the iv of arch 363 by the U.S. Trustee. As discussed in Section 5 -3 IV.A.4, Statutory Committees, committees generally o. 14 n, N in the case, protect the rights and interests of unsecured provide a voice for unsecured .creditors Brow hv ixset creditors, and serve as a lstatutory watchdog or check on the debtor in possession. in B cited Traditionally, unsecured creditors were viewed as one of the more vulnerable classes of stakeholders in a chapter 11 case. Many debtors had liquidity or other resources to pay their secured creditors and administrative and priority claimholders, but often did not generate sufficient value to pay unsecured creditors in full, or even a meaningful distribution, in the case. Moreover, the Bankruptcy Code requires a debtor to pay the allowed claims of secured creditors and holders of administrative claims in order to confirm a chapter 11 plan. Accordingly, secured creditors and the holders of administrative claims typically have sufficient protection in a chapter 11 case. In recent years, the more vulnerable (or perceived vulnerable) classes of stakeholders in a chapter 11 case have moved up in a debtor’s capital structure. The debtor often does not generate sufficient value to pay its administrative claimants. As “administratively insolvent” cases have become more common, some practitioners have questioned whether administrative claimants need representation through the committee structure. Most courts have rejected requests for the appointment of administrative claims committees. The one notable exception is In re LTV Steel. Administrative Claims Committee: Recommendations and Findings Committees serve oversight and representative functions that generally are lacking in the chapter 11 case. The latter is particularly important in the context of unsecured creditors and, in some cases, V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 180 of 402 Bankruptcy Institute equity security holders whose distributions in the chapter 11 case are determined largely by the value of the estate, or value generated for the benefit of the estate during the case. The Bankruptcy Code does not require a minimum distribution to general unsecured creditors or equity security holders. Rather, plan confirmation standards require only that these parties receive at least as much as they would receive in a chapter 7 liquidation and that, to the extent they are impaired, no junior class receive a distribution. The Commissioners did not perceive the same risks for administrative claimholders. Although the value generated in a case may prove inadequate and administrative claims may not be satisfied in full, the Bankruptcy Code incorporates protections for these claimholders at least in the confirmation context. In addition, the Commissioners noted that the recommended principles on section 363x sales propose extending similar protection to administrative claimholders in the context of sales of all or substantially all of a debtor’s assets. Accordingly, the Commission determined that the additional time and expense often associated with statutory committees were not necessary or warranted with respect to administrative claims. 3. WARN Act Claims Recommended Principles: 16 1, 20 ber 2 the Worker When a plant closing, mass layoff, or other triggering Novem under event n ed o Adjustment and Retraining Notification Act r(the “WARN Act”) occurs on or chiv 63 a -353claims for (or on behalf of) employees after the filing of the bankruptcy petition, . 14 , No for damages under the v. Brown Act should be treated as administrative claims WARN eth Blixs under section  i503(b) of the Bankruptcy Code for the number of postpetition ed n cit days comprising the violation, provided that the claims are otherwise entitled to protection under the WARN Act. WARN Act Claims: Background The Worker Adjustment and Retraining Notification Act (the “WARN Act”)651 requires covered employers to provide affected employees with at least 60 days’ advance notice prior to effecting a plant closing or covered mass layoff. The WARN Act is intended to “provide[] protections to workers, their families and communities by requiring employers to provide notification 60 calendar days in advance of plant closings and mass layoffs. Advance notice provides workers and their families some transition time to adjust to the prospective loss of employment, to seek and obtain alternative jobs and, if necessary, to enter skill training or retraining that will allow these workers to successfully 651 29 U.S.C. §§ 2101–2109.  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 181 of 402 ABI Commission to Study the Reform of Chapter  compete in the job market.”652 When the required notice is not given, employers may be liable for back pay and benefits for the period of the violation, up to a maximum of 60 days.653 There are statutory exceptions that, if established by the employer, would permit a notification period of fewer than 60 days. Under the “faltering company” exception, a company may provide fewer than 60 days’ notice of a plant closing if, during the 60 days prior to shutdown, the company was “actively seeking capital or business, which, if obtained, would have enabled the employer to avoid or postpone the shutdown and the employer reasonably and in good faith believed that giving the notice required would have precluded the employer from obtaining the needed capital or business.”654 In addition, when a mass layoff or plant closing is caused by business circumstances that were “not reasonably foreseeable as of the time the notice would have been required,” the notification period may be reduced.655 Similarly, a natural disaster may reduce the notice period.656 An employer relying one of the statutory bases for a reduction in the notice period must still provide “as much notice as is practicable.”657 Other defenses to WARN Act liability may apply as well.658 Employees aggrieved by a violation of the notice requirement, or their representatives,659 may assert claims for back pay for “each day of the violation,” and for benefits under an employee benefit plan.660 Liability is calculated for the period of the violation, up to a maximum of 60 days. Certain reductions may apply, for example, for any wages paid by the employer for the period of the violation.661 Liability for WARN Act damages when the requisite notice was not given 016 been analogized to , 2 has er 21 emb such pay to be earned in full liability for severance pay in lieu of notice, when courts haveNov n viewed ed o chivWARN Act damages give rise to a right to upon the triggering event. Thus, courts have held ar 3 that 3536 . 14payment upon the occurrence of the event triggering the violation (i.e., the employment termination No wn, or mass layoff). Accordingly,th v. Bro the timing of the triggering event generally has determined the payment lixse classification of citedclaim for bankruptcy purposes. When employment loss occurred prepetition, the in B due to a plant closing or mass layoff that is covered by the WARN Act, the WARN Act damages claim generally has been held to arise in full prepetition, even if the termination occurred close in time to a bankruptcy filing such that a portion of the 60-day period covered by the notice requirement 652 20 C.F.R. §  639.1(a). See In re FF Acquisition Corp., 438 B.R. 886, 891 (Bankr. N.D. Miss. Oct. 26, 2010), aff ’d and appeal dismissed sub nom. Angles v. Flexible Flyer Liquidating Trust, 471 B.R. 182 (N.D. Miss. 2012), aff ’d sub nom. In re Flexible Flyer Liquidating Trust, 511 Fed. App’x 369 (5th Cir. 2013). See also Hotel Employees & Rest. Employees Int’l Union Local 54 v. Elsinore Shore Assocs., 173 F.3d 175, 182 (3d Cir. 1999) (noting adoption of WARN Act “in response to the extensive worker dislocation that occurred in the 1970s and 1980s”). 653 In re FF Acquisition Corp., 438 B.R. 886, 891 (Bankr. N.D. Miss. Oct. 26, 2010), aff ’d and appeal dismissed sub nom. Angles v. Flexible Flyer Liquidating Trust, 471 B.R. 182 (N.D. Miss. 2012), aff ’d sub nom. In re Flexible Flyer Liquidating Trust, 511 Fed. App’x 369 (5th Cir. 2013). See also 29 U.S.C. § 104(a)(1)(A)–(B). 654 29 U.S.C. § 2102(b)(1). See 20 C.F.R. § 639.9(a) (setting forth qualifying requirements for “faltering business” exception). 655 29 U.S.C. § 2102(b)(2). See 20 C.F.R. § 639.9(b)(2) (setting forth indicators where business circumstance may not be reasonably foreseeable). 656 See 29 U.S.C. § 2102(b)(2)(B); 20 C.F.R. § 639.9(c). 657 29 U.S.C. § 2102(b)(3). 658 E.g., id. § 2104(a)(4) (providing that, in an action to recover damages, where an employer proves “reasonable grounds for believing that the act or omission was not a violation” of the statute, court may reduce the amount of the liability). See also id. § 2103 (listing exemptions where plant closing or mass layoff constitutes a strike or lockout, or closing relates to a temporary facility). 659 See United Food & Commercial Workers Local 751 v. Brown Grp., Inc., 517 U.S. 544 (1996) (holding that union representing affected employees has standing under WARN Act to sue for damages on their behalf). 660 See 29 U.S.C. § 2104(a)(1)(A)–(B). 661 See id. § 2104(a)(1), (2). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 182 of 402 Bankruptcy Institute included time following the petition date.662 When applicable, prepetition WARN Act claims have been held to be subject to the wage priority.663 When the event triggering WARN Act liability occurs postpetition, courts have held that employees terminated postpetition have claims that accrue in full postpetition.664 Thus, these cases hold that WARN Act claims based on a postpetition termination are entitled to administrative priority.665 One case held differently, although in the context of deciding whether a WARN Act claim should proceed as an adversary proceeding or through the claims adjudication process. In In re Circuit City, the plaintiff was terminated postpetition, but the date on which notice should have been given, had his employer complied with the WARN Act, was eight days prior to the petition date.666 The debtor argued that the claim arose on the date that notice was due, not on the date of termination. The court’s rationale was that, as of the date the company gave notice of the store closing, which occurred prior to the bankruptcy, the employees had a “contingent” claim against the debtor, in the event the debtor’s notice was inadequate under the WARN Act.667 Thus, the court concluded that (at least for purposes of determining the mechanism for pursing the claim) the claim arose on the date notice was due. The court thus concluded that the claim should proceed through the claims adjudication process and dismissed the plaintiff ’s adversary proceeding. WARN Act Claims: Recommendations and Findings 16 1, 20 ber 2 v m In considering cases involving postpetition closures or other triggeringeevents under the WARN Act, n No ed o iv the Commission agreed that the event giving rise to 363 arch Act damages is the loss of employment WARN -35 4 due to the WARN Act triggering event, and No. 1the date the notice should have been given. In order , not rown B h v. xset n Bli Corp., 394 B.R. 765, 772–73 (Bankr. D. Del. 2008); Int’l Bhd. of Teamsters, AFL-CIO v. Kitty 662 See, e.g., In re Powermate ed i Holding cit 663 664 665 666 667  Hawk Int’l, Inc. (In re Kitty Hawk, Inc.), 255 B.R. 428, 438 (Bankr. N.D. Tex. 2000) (Bankr. N.D. Tex. 2000). See also In re First Magnus Fin. Corp., 403 B.R. 659, 665–66 (D. Ariz. 2009) (holding that WARN Act rights of workers discharged without requisite notice accrue in their entirety upon termination and damages are vested prepetition); In re Continentalafa Dispensing Co., 403 B.R. 653, 658 (Bankr. E.D. Mo. 2009) (“Here, Plaintiff was terminated before Debtors filed their petitions and therefore, Plaintiff performed no work after the petitions were filed. Thus, Plaintiff has a prepetition claim.”). E.g., In re Powermate Holding Corp., 394 B.R. 765, 772–73 (Bankr. D. Del. 2008); Int’l Bhd. of Teamsters, AFL-CIO v. Kitty Hawk Int’l, Inc. (In re Kitty Hawk, Inc.), 255 B.R. 428, 438 (Bankr. N.D. Tex. 2000). Courts generally have held that WARN Act damages are considered “wages.” E.g., In re Powermate Holding Corp., 394 B.R. 765, 771 (Bankr. D. Del. 2008); In re Hanlin Grp., Inc., 176 B.R. 329, 333 (Bankr. D.N.J. 1995); In re Riker Indus., Inc., 151 B.R. 823 (Bankr. N.D. Ohio 1993); In re Cargo, Inc., 138 B.R. 923, 927 (Bankr. N.D. Iowa 1992). Courts have considered whether to apportion WARN Act damages between prepetition and postpetition periods under section 503(b)(1)(a)(A)(ii), a section added to the Bankruptcy Code pursuant to BAPCPA. However, although courts have consistently declined to apply revised section 503(b) where a WARN Act event occurs prepetition, they have not agreed on an interpretation of this provision that would encompass WARN Act damages. Compare In re First Magnus Fin. Corp., 390 B.R. 667, 679 (Bankr. D. Ariz. 2008) (interpreting section 503(b)(1)(a)(A)(i) and (ii) such that both subparts must apply for subpart (ii) to apply at all, so that statute is inapplicable where no services are rendered postpetition) with In re Continentalafa Dispensing Co., 403 B.R. 653, 658 (Bankr. E.D. Mo. 2009) (holding that BACPA was not meant to “slant” the law to cover prepetition terminations); In re Powermate Holding Corp., 394 B.R. 765, 777 (Bankr. D. Del. 2008) (holding that statutory use of “and” meant that subparts (i) and (ii) were independent examples of administrative claims, but BAPCPA was not meant to “drastically change the outcome of prepetition employment terminations”). But see In re Phila. Newspapers, LLC, 433 B.R. 164, 174–75 (Bankr. E.D. Pa. 2010) (disagreeing with Powermate’s conclusion that statute must be applied based on the timing of accrual or vesting of right to payment, but holding that statute is inapplicable to back pay award based upon contractual violation). The Commission did not address whether an employment loss resulting from a prepetition WARN Act triggering event could nonetheless fall within BAPCPA. E.g., In re Beverage Enters., Inc., 225 B.R. 111, 115–16 (Bankr. E.D. Pa. 1998) (holding that WARN Act claims of workers who were terminated approximately four months after chapter 11 petition was filed were deemed “severance” benefits that was earned immediately upon termination, that it was indisputable that termination occurred postpetition, and that WARN Act claims were therefore entitled to administrative priority); In re Hanlin Grp., Inc., 176 B.R. 329, 334 (Bankr. D.N.J. 1995) (“Back pay under WARN [Act] is deemed to be earned at the date of termination. Because the date of termination occurred postpetition, any back pay due for a WARN [Act] violation will be deemed as earned postpetition, and therefore in the nature of wages for services rendered after the commencement of the case entitled to administrative priority status.”). In re Circuit City Stores, Inc., 2010 WL 120014 (Bankr. E.D. Va. Jan. 7, 2010). Id. at *4. V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 183 of 402 ABI Commission to Study the Reform of Chapter  to violate the WARN Act, an employer must effect a mass layoff or plant closing that takes place without providing the requisite WARN Act notice. Until such an event occurs, there has been no violation of the WARN Act. Thus, aggrieved employees should have a postpetition administrative claim for WARN Act damages for the number of postpetition days comprising the violation. The principle would apply assuming the claim for WARN Act damages is otherwise determined to be a valid claim under the WARN Act. The Commission did not address the substance of any potential defenses that may be applicable under the WARN Act, and instead proposed its recommendation strictly on the basis that the appropriate forum has otherwise determined that damages were owed. The Commission considered whether a bright-line rule that postpetition WARN Act violations give rise to administrative claims might create an incentive for companies with plants or operations that are of doubtful viability to close such plants or operations prepetition rather than trying to turn them around postpetition and risk an administrative priority WARN Act claim if the turnaround effort fails. However, strategic decisions based solely on the economics of a potential WARN Act claim seem unlikely, particularly because most courts already determine payment priority status based on the timing of the triggering WARN Act event, and the Commission’s clarifying recommendation would not represent a significant change in current law. 4. Severance Benefits 16 1, 20 ber 2 vem Recommended Principles: n No ed o rchiv 63 a -353 An employee’s claim for postpetition severance benefits should be eligible . 14 , No rown for treatment as anv.administrative claim under section 503(b)(1)(A)(i) of the B h xset Bankruptcy Code. n Bli i cited If an employee is terminated postpetition and entitled to severance benefits that are calculated based on length of service, the employee’s claim against the estate for severance benefits should be bifurcated between the prepetition and postpetition periods, such that the employee is permitted to assert (i) a prepetition claim for severance benefits based on prepetition service and (ii) a postpetition administrative claim for severance benefits based on postpetition service. Such an employee also should be permitted to assert a priority claim for any qualifying portion of the prepetition severance benefits claim under section 507. Severance Benefits: Background Severance benefits generally are described as payments due to an employee as a result of the termination of employment or some other significant adjustment to or change in the employee’s employment circumstances.668 In a chapter 11 case, a debtor may reduce its workforce because, for example, it is downsizing, restructuring its business operations, or liquidating. Employees impacted 668 5 Collier on Bankruptcy ¶ 507.06[5](b) (16th ed. 2012). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 184 of 402 Bankruptcy Institute by these decisions may be covered by prepetition severance plans. These plans may be based on (i) a fixed payment at termination in lieu of notice, or (ii) the terminated employee’s length of service.669 The treatment of employees’ severance benefits in the chapter 11 case is important to both the debtor and its employees. The primary issue in this respect is whether the severance benefits are treated as prepetition unsecured claims or postpetition administrative claims. Section 503(b) of the Bankruptcy Code grants administrative priority to the “actual, necessary costs and expenses of preserving the estate.”670 These claims generally include costs associated with operating the debtor’s business and administering the estate during the chapter 11 case. Section 503(b)(1)(A)(i) specifically identifies “wages, salaries, and commissions for services rendered after the commencement of the case” as administrative claims.671 These claims are entitled to payment priority (i.e., paid before prepetition unsecured claims are paid) and generally must be paid in full under the chapter 11 plan. Accordingly, the characterization of severance benefits can have significant consequences for the debtor and the terminated employees. Although not specifically referenced in the statute, courts analyze the treatment of severance benefits under section 503(b)(1)(A)(i).672 In general, courts tend to treat severance benefits as prepetition or postpetition claims based on the type of severance plan at issue: if it is a lump sum payment plan in lieu of notice, courts treat the benefits as postpetition claims;673 if it is a plan based on length of service, courts generally allocate the benefits between prepetition and postpetition claims according 6 to when the severance benefits were earned.674 Notably, the Second Circuit has 1, 201 the allocation rejected ber 2 of severance benefits — even under plans based on length of service vemfinding that the purpose of No — d on chive ar severance benefits is to compensate the employees for3termination, which is the event that should 3536 . 14-675 Courts in the Second Circuit thus treat all true determine the treatment of claims in bankruptcy. , No own v. Br severance benefits triggered byeth postpetition termination as postpetition administrative claims. a Blixs Moreover, in the context of section 507(a)(4) priority claims, the Fourth Circuit has determined that ed in cit severance compensation was “earned” upon the employees’ termination.676 669 See, e.g., Lines v. Sys. Bd. of Adjustment No. 94 Bhd. of Ry., Airline & Steamship Clerks (In re Health Maint. Found.), 680 F.2d 619, 621 (9th Cir. 1982); Richard F. Broude, Reorganizations Under Chapter 11 of the Bankruptcy Code 6-12.3 (Law Journal Press, 2005). 670 11 U.S.C. § 503(b). 671 Id. § 503(b)(1)(A)(i). 672 Id. Before a debtor can provide or pay any insider of the debtor administrative priority severance pay, the debtor must satisfy the requirements of section 503(c)(2). Id. § 503(c). The Commission did not address the payment of severance or other compensation to insiders under section 503(c). 673 5 Collier on Bankruptcy ¶¶ 503.06[7](d), 507.06[5](b) (16th ed. 2012). 674 See, e.g., Preferred Carrier Svcs. Va., Inc. v. Phones For All, Inc.(In re Phones For All, Inc.), 288 F.3d 730 (5th Cir. 2002); Bachman v. Commercial Fin. Svcs., Inc. (In re Commercial Fin. Svcs., Inc.), 246 F.3d 1291, 1294 (10th Cir. 2001); In re Roth Am., Inc., 975 F.2d 949 (3d Cir. 1992); Lines v. Sys. Bd. of Adjustment No. 94 Bhd. of Ry., Airline & Steamship Clerks (In re Health Maint. Found.), 680 F.2d 619, 621 (9th Cir. 1982); Cramer v. Mammoth Mart, Inc. (In re Mammoth Mart, Inc.), 536 F.2d 950 (1st Cir. 1976); In re Public Ledger, Inc., 161 F.2d 762 (3d Cir. 1947); Rawson Food Svcs., Inc. v. Creditors’ Comm. (In re Rawson Food Svcs., Inc.), 67 B.R. 351 (Bankr. M.D. Fla. 1986). 675 Rodman v. Rinier (In re W.T. Grant Co.), 620 F.2d 319 (2d Cir. 1980), superseded by statute (Bankruptcy Code) as recognized in In re Hooker Investments, Inc, 145 B.R. 138 (Bankr. S.D. New York. 1992); Straus-Duparquet, Inc. v. Local Union No. 3, Int’l Bhd. of Elec. Workers, AFL-CIO (In re Straus-Duparquet, Inc.), 386 F.2d 649, 651 (2d Cir. 1967), superseded by statute (Bankruptcy Code) as recognized in In re Drexel Burnham Lambert Grp., Inc., 138 B.R. 687, 711 (Bankr. S.D.N.Y. 1992) See also Supplee v. Bethlehem Steel Corp. (In re Bethlehem Steel Corp.), 479 F.3d 167, 175 (2d Cir. 2007) (“The key inquiry is whether the payment is a new benefit earned at termination or instead an acceleration of benefits [which the employee accrued over time].”). 676 Matson v. Alarcon, 651 F.3d 404, 409 (4th Cir. 2011). The Fourth Circuit specifically highlighted the difference in language between section 503(b)(1)(A)(i) and section 507(a)(4), noting that the former — dealing with characterization of employee payments as administrative claims — expressly tied such claims to “services rendered after the commencement of the case.” Id. Accordingly, the Fourth Circuit’s decision may have limited application in the analysis of severance benefits arising from a postpetition termination.  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 185 of 402 ABI Commission to Study the Reform of Chapter  Severance Benefits: Recommendations and Findings The Commission considered two issues with respect to severance benefits in chapter  11: first, whether section 503(b)(1)(A)(i) should be amended to specifically reference severance benefits, in addition to “wages, salaries, and commissions for services rendered after the commencement of the case”; and second, whether the Bankruptcy Code should be amended to address the treatment of severance benefits relating to a postpetition termination or other triggering event. The Commission agreed that “severance benefits” should be added to section 503(b)(1)(A)(i) and largely viewed this change as a technical amendment. The Commissioners engaged in a more in-depth analysis of the treatment of severance benefits as prepetition or postpetition claims. The Commissioners discussed the underlying nature of severance benefits. Some of the Commissioners viewed severance benefits in all circumstances as compensation for the termination itself, not wages or compensation for services previously rendered. These Commissioners emphasized that severance benefits are intended to mitigate at least some of the hardship imposed upon employees by the termination of employment and the resulting loss of wages and benefits. They also observed that, even if a severance plan uses length of service to calculate the amount of the severance benefit, that reference is solely a calculation tool and does not necessarily speak to the nature or purpose of the benefit. Finally, these Commissioners highlighted the additional burden on more senior employees imposed by an allocation rule. These employees may have the majority of their severance benefits calculated based on a long prepetition 016 , 2 tenure with the debtor, er 21 emb arguably penalizing them for their loyalty and service to the Nov debtor. n o ived arch 363 Other Commissioners strongly believed that -35 14 severance benefits calculated based on length of service No. n, should be deemed earned whenBrow services were provided. This approach requires an allocation . such eth v s of the severance ibenefitsixbetween the prepetition and postpetition periods. These Commissioners in Bl c ted observed that many claims are bifurcated in this manner under the Bankruptcy Code, and they did not find justification for varying it in the employment context. They also emphasized that administrative claims must be grounded in value provided to the estate — whether to preserve or enhance the estate — and focused on the general purpose and language of section 503(b) of the Bankruptcy Code. In vetting these issues, the Commission considered the U.S. Supreme Court’s decision in United States v. Quality Stores.677 In Quality Stores, the Supreme Court held that severance payments were wages for purposes of FICA, and provided guidance on how to characterize these types of payments. Specifically, the Supreme Court explained: [S]everance payments often vary, as they did here, according to the function and seniority of the particular employee who is terminated. For example, under both termination plans, Quality Stores employees were given severance payments based on job grade and management level. And under the second termination plan, nonofficer employees who had served at least two years with their company received more in severance pay than nonofficer employees who had not — a standard example of a company policy to reward employees for a greater length of good service and loyalty. 677 United States v. Quality Stores, Inc., 134 S. Ct. 1395 (2014). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 186 of 402 Bankruptcy Institute In this respect severance payments are like many other benefits employers offer to employees above and beyond salary payments. Like health and retirement benefits, stock options, or merit-based bonuses, a competitive severance payment package can help attract talented employees. Here, the terminations leading to the severance payments were triggered by the employer’s involuntary bankruptcy proceeding, a prospect against which employees may wish to protect themselves in an economy that is always subject to changing conditions.678 Some of the Commissioners asserted that the Supreme Court’s holding in Quality Stores suggested that the characterization of severance benefits as payment either due upon termination or for services previously provided by an employee should be left to the courts to resolve on a case-by-case basis. The advisory committee recommended this approach as well. Other Commissioners did not necessarily disagree with this assessment, but argued that the Bankruptcy Code should still clarify the treatment of severance benefits if the court determines they are earned based upon length of service under the applicable severance plan. The Commission recommended that the Bankruptcy Code codify an allocation rule for severance benefits triggered postpetition and calculated based on length of service. For additional views on the recommended principles for severance benefits, see Appendix G. 16 1, 20 ber 2 vem n No ed o rchiv 63 a -353 . 14 , No rown B h v. Recommended Principles: xset n Bli i cited F. General Valuation Standards The court should continue to determine valuation issues based on the evidence presented by the parties. The Bankruptcy Code should not dictate the valuation methodology to be used by the court in resolving these issues. Accordingly, no change to existing law is suggested on this point. The court should be permitted to use a court-appointed expert and to rely on the hearing testimony of a court-appointed expert in addition to any expert offered by the parties to assist in determining valuation issues. Section 105 of the Bankruptcy Code and Rule 706 of the Federal Rules of Evidence permit the court to appoint valuation experts. Accordingly, no change to existing law is suggested on this point. General Valuation Standards: Background Valuation issues arise at various points in a chapter 11 case. Parties may need a valuation of the debtor’s assets early in the case to resolve, for example, a secured creditor’s request for adequate protection under section 361 or to assess a proposed sale of some or all of a debtor’s assets under section 363. They may need to revisit valuation issues later in the case in connection with creditors’ 678 Id. at 1499.  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 187 of 402 ABI Commission to Study the Reform of Chapter  requests for relief from the automatic stay or confirmation of a chapter 11 plan. Indeed, the value of a debtor’s assets impacts adequate protection requests, postpetition financing terms and collateral, the amount of secured creditors’ allowed secured claims against the estate, distributions available to creditors in the case, the feasibility of a plan, and the application of the absolute priority rule in the plan cramdown context.679 Nevertheless, the Bankruptcy Code does not address valuation issues directly in the chapter 11 context or mandate a particular methodology for valuing a debtor’s assets. Accordingly, courts generally determine the value of a debtor’s assets, and resolve any related valuation disputes, based on the evidence presented by the parties at the hearing on the matter. This method, commonly referred to as “judicial valuation,” introduces some uncertainty into the process, but it also allows courts to consider various valuation methodologies and to tailor the valuation to the facts and circumstances at hand. Parties may value the debtor’s assets based on, among other factors, a balance sheet analysis, a discounted cash flow analysis, or market comparables.680 Parties typically introduce this evidence through expert testimony at the hearing, and courts weigh and consider this testimony and the other evidence in reaching their valuations. Empirical studies suggest that courts thoughtfully consider valuation disputes and do not simply resolve such matters by splitting the difference.681 In addition to relying on the parties’ experts, courts also may appoint an expert to testify on valuation issues. Rule 706 of the Federal Rules of Evidence provides that “the court may appoint any expert 16 that the parties agree on and any of its own choosing.” In addition,r the 2court may establish the 1, 0 be 2 expert’s duties and compensation in the order of appointment.ovem N Court-appointed experts generally d on chive some courts have invoked section 105 of ar are subject to discovery and cross-examination.3Moreover, 5 63 14-3 . Federal Rules of Evidence to appoint “experts with teeth,” the Bankruptcy Code and Rule 706 of,the No own v. Br served both as a valuation expert for the court and a mediator in that the court-appointed texpert eh Blixs between the partiesdon the valuation issues.682 e in cit General Valuation Standards: Recommendations and Findings In general, valuation is more art than science. Regardless of the valuation methodology, the results depend on a variety of factors, including timing, market conditions, assumptions, and appraisers.683 As one court explained: 679 Section 506(a)(1) provides that a secured creditor’s claim is secured to the extent of the value of its collateral and that “[s]uch value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property, and in conjunction with any hearing on such disposition or use or on a plan affecting such creditor’s interest.” 11 U.S.C. § 506(a)(1). In addition, section 506(a)(2) provides more specific guidance in the case of an individual under chapter 7 or 13. Id. § 506(a)(2) (mandating valuation based on the replacement value of the property as of the petition date in individual chapter 7 and 13 cases). 680 See Bernard Trujillo, Patterns in a Complex System: An Empirical Study of Valuation in Business Bankruptcy Cases, 53 UCLA L. Rev. 356 (2005). In addition, parties may present testimony of a potential purchaser or prospective user of the property at issue; the contract method or rates agreed to by the parties, or general observations about market or industry trends for such property. Id. at 383–85. 681 Compare id. at 370 (study of 180 observations drawn from 145 published opinions reported in the Westlaw computer database decided from 1979 through 1998, finding “complete success for the debtor or for the creditor — about equally . . . [C]ourts very rarely split the difference between the debtor’s and the creditor’s numbers”) with Keith Sharfman, Judicial Valuation Behavior: Some Evidence from Bankruptcy, 32 Fla. St. U. L. Rev. 387, 396 (2005) (study of 24 valuation disputes, finding “(1) bankruptcy judges on average allocated 65.2% of the value in controversy to debtors and only 34.8% to secured creditors; and (2) bankruptcy judges were more than three times as likely to allocate most of the value in controversy to debtors as they were to secured creditors”). See generally supra note 66 and accompanying text (generally discussing limitations of chapter 11 empirical studies). 682 See, e.g., In re Calpine Corp., 377 B.R. 808 (Bankr. S.D.N.Y. 2007). 683 See, e.g., Douglas G. Baird & Donald S. Bernstein, Absolute Priority, Valuation Uncertainty, and the Reorganization Bargain, 115 Yale L.J. 1930, 1941–42 (2006) (“A business, however, cannot be valued with such precision. There are different methods of valuing a business, but in the end all are merely estimates of the present value of the business’s future earning capacity.”). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 188 of 402 Bankruptcy Institute [T]he valuation of an enterprise . . . is an exercise in educated guesswork. At worst it is not much more than crystal ball gazing. There are too many variables, too many moving pieces in the calculation of value . . . for the court to have great confidence that the result of the process will prove accurate in the future. Moreover, the court is constrained by the need to defer to experts and, in proper circumstances, to Debtors’ management.684 The Commissioners discussed the uncertainty surrounding valuation generally and considered whether judicial valuation significantly enhanced this uncertainty. Such inherent uncertainty is recognized in the legislative history of the Bankruptcy Code, which explains that, “[a]s Peter Coogan has aptly noted, such a valuation [of the enterprise in connection with applying the absolute priority rule] is usually ‘a guess compounded by an estimate’.”685 The Commission reviewed valuation methodologies used as part of, or independent from, judicial valuation to value a debtor’s assets or business as a going concern. These methodologies include discounted cash flow, market comparables, and securities based valuations, among others. The Commissioners explored how different components of these valuation methodologies are subject to varying interpretation or application, which can cause fluctuation in asset or business valuations.686 For example, an empirical study of companies emerging from chapter 11 prior to 1994 finds “that estimates of value are generally unbiased, but the estimated values are not very precise — the sample ratio of estimated value to market value varies from below 20 percent to more than 250 percent.”687 The authors of this study suggest that the variance in valuations may result from the administrative bankruptcy process or from strategic distortion. “The strategic distortion explanation 16 1 20 for the imprecision of the cash flow forecasts implies that the valuation errors rare ,systematically related be 2 m No strengths of the parties.”688 to proxies for the competing financial interests and relative bargaining ve d on ive arch 363 -35 o. The Commissioners also examined the impact 14 valuation uncertainty on chapter 11 cases. Many n, N of Brow of the Commissioners commentedv.that although valuation litigation can be time-consuming and th lixse B expensive,689 judicial cited in valuation and any related uncertainty can encourage negotiated resolutions.690 A negotiated resolution of valuation uncertainty aligns with the consensual nature of the chapter 11 process. Although disputes arise and not every chapter 11 is consensual, commentators typically describe “the goal of a Chapter 11 restructuring [as achieving] a consensual plan of reorganization.”691 Chapter 11’s preference for consensual resolutions evolved at least in part from business reorganization’s Chapter XI roots. A consensual plan between the debtor and its unsecured creditors was the hallmark of the Chapter XI process under the Bankruptcy Act.692 The Commissioners found continued utility in the judicial valuation approach, including the flexibility it gives the parties in selecting the best valuation methodology. Judicial valuation allows the court and parties to consider market valuations, book and adjusted book valuations, and other 684 In re Mirant Corp., 334 B.R. 800, 848 (Bankr. N.D. Tex. 2005). 685 1977 House Judiciary Committee Report on Public Law 95-598, at 222. 686 See Baird & Bernstein, supra note 683, at 1943 (“Differences of 10% are almost inevitable, and often the differences are far larger.”). 687 Stuart C. Gilson et al, Valuation of Bankrupt Firms, 13 Rev. Fin. Studies 43–74 (2000) (“This study explores the relation between the market value of 63 publicly traded firms emerging from Chapter 11 and the values implied by the cash flow forecasts in their reorganization plans.”). 688 Id. 689 In re Mirant Corp., 334 B.R. 800, 809, 824 (Bankr. N.D. Tex. 2005) (conducting 27-day valuation trial with separate valuation experts for key parties testifying to values ranging from $7.2 billion to $13.6 billion). 690 See Baird & Bernstein, supra note 683, at 1963 (“These dynamics regularly lead to negotiated reorganization plans with basic features consistent with the idea that valuation uncertainty plays a key role in dictating the contours of such plans.”). 691 Miller & Waisman, Is Chapter 11 Bankrupt?, supra note 26, at 144–45. 692 For discussion of Chapter XI of the Bankruptcy Act, see Section III.A, Brief History of U.S. Business Reorganization Laws.  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 189 of 402 ABI Commission to Study the Reform of Chapter  factors that may be relevant to particular debtor and its reorganization efforts. The Commissioners were also mindful, however, of witness testimony suggesting that judges may need assistance with complex or contested valuations. For example, the Honorable James Peck of the U.S. Bankruptcy Court for the Southern District of New York testified as follows: An inexperienced judge navigating unfamiliar territory introduces an extra element of risk and uncertainty into what necessarily is an unpredictable process in which the skills and personality of the advocate and witness may be the most important variables. An experienced judge is likely to be more facile in deciding these questions but reliability and predictability remain a problem because the experienced judge will be applying his or her own valuation judgments without being able to confer with someone deeply grounded in the subject. Such a valuation professional would be more skilled than most judges in being able to verify or question the assumptions and adjustments that so often dictate the conclusions reached. Valuation is an art more than a science, and it would be helpful for the Court to have access to a seasoned art critic in deciding whether a particular challenged valuation is genuine or a fake.693 The Commission reviewed witness testimony and related anecdotal evidence on valuation. The Commission agreed that courts should be permitted and encouraged to appoint valuation experts in cases in which such an expert can provide assistance to the court. The Commissioners debated whether an appointed expert should be permitted to consult with, and to advise the court, but not necessarily be called 6 , 201 to testify in the case. After debating the benefits to the court and the due ber 21 and procedural concerns process vem n No for the parties, the Commission agreed that, if the court intends to rely on the court-appointed valuation ed o iv arch expert, such expert must testify in the case 14-35be3subject to cross-examination. The Commissioners and 36 o. also observed that estate neutrals Brown, the recommended principles could now perform the expanded under N . eth v role, including that ofnmediator, served by court appointed valuation experts in the past. Finally, the Blixs i cited Commissioners evaluated the language of Rule 706 of the Federal Rules of Evidence and found it sufficient as written for the contemplated role of court-appointed valuation experts. G. Standard for Reviewing Settlements and Compromises Recommended Principles: The principles and standards of Bankruptcy Rule 9019 should be codified to foster uniform application of a court’s authority to approve a settlement or compromise of controversies in a chapter 11 case. Accordingly, the court, after notice and a hearing, should approve a trustee’s proposed settlement or compromise of a controversy only if the court finds, based on the evidence presented, that the proposed settlement or compromise is reasonable and in the best interests of the estate. 693 Written Statement of Honorable James M. Peck, VALCON Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 2 (Feb. 21, 2013), available at Commission website, supra note 55. V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 190 of 402 Bankruptcy Institute Standard for Reviewing Settlements and Compromises: Background In general, “compromises are favored in bankruptcy.”694 Negotiated resolutions of disputes can create efficiencies in the process and cost savings for the parties. Bankruptcy Rule  9019, like its predecessor Rule 919 under the Bankruptcy Act, provides a process for parties to request court approval of settlements and compromises. Specifically, Bankruptcy Rule 9109 states, in relevant part: “On motion by the trustee and after notice and a hearing, the court may approve a compromise or settlement.”695 Notably, neither the Bankruptcy Rules nor the Bankruptcy Code provide a standard or criteria for the court to use in assessing proposed settlements and compromises. Given general bankruptcy policy and the lack of guidance in the Bankruptcy Rules and the Bankruptcy Code, courts tend to invoke a “presumption in favor of settlements,” and approve a proposed settlement or compromise unless it “‘fall[s] below the lowest point in the range of reasonableness.’”696 Various courts have developed factors to assist in this determination, but not all courts use the same factors or apply the factors in a uniform manner.697 This variation can cause uncertainty for the parties filing motions under Bankruptcy Rule 9019 and inconsistent rulings on proposed settlements and compromises. In addition, courts take different approaches to reviewing settlements and compromises incorporated into plans of reorganization.698 This latter issue is discussed below.699 Standard for Reviewing Settlements and Compromises: Recommendations 16 1, 20 and Findings ber 2 vem n No ed o chivthe chapter  11 case, including claims A trustee may seek to settle any number of disputesr in 3a 3536 . 14resolution matters, avoidance claims, and o , N prepetition litigation. Because any such settlement own necessarily impacts the estate —eth v. Brbecause the estate will fund at least a portion of the settlement either lixs in third parties are being compromised — the court and parties in interest or the estate’s claims againstB cited 700 694 Myers v. Martin (In re Martin), 91 F.3d 389, 393 (3d Cir. 1996), quoting 9 Collier on Bankruptcy ¶ 9019.03[1] (15th ed. 1993). 695 Fed. R. Bankr. P. 9019(a). 696 In re Tower Auto., Inc., 342 B.R. 158, 164 (Bankr. S.D.N.Y. 2006), aff ’d, 241 F.R.D. 162 (S.D.N.Y. 2006). See also Hicks, Muse & Co., Inc. v. Brandt (In re Healthco Int’l, Inc.), 136 F.3d 45, 50 n.5 (1st Cir. 1998) (holding that court may accord deference to the position of the trustee or debtor in possession); In re WorldCom, Inc., 347 B.R. 123, 137 (Bankr. S.D.N.Y. 2006) (“While the bankruptcy court may consider the objections lodged by parties in interest, such objections are not controlling . . . the bankruptcy court must still make informed and independent judgment.”); In re Hibbard Brown & Co., Inc., 217 B.R. 41, 46 (Bankr. S.D.N.Y. 1998) (holding that court may exercise its discretion under Bankruptcy Rule 9019 “in light of the general public policy favoring settlements”). 697 Courts consider a variety of factors, including: (1) the balance between the litigation’s possibility of success and the settlement’s future benefits; (2) the likelihood of complex and protracted litigation, with its attendant expense, inconvenience and delay, including the difficulty in collecting on the judgment; (3) the paramount interests of the creditors, including each affected class’s relative benefits and the degree to which creditors either do not object to or affirmatively support the proposed settlement; (4) whether other parties in interest support the settlement; (5) the competency and experience of counsel supporting, and the experience and knowledge of the bankruptcy court judge reviewing, the settlement; (6) the nature and breadth of releases to be obtained by officers and directors; and (7) the extent to which the settlement is the product of arm’s length bargaining. In re Iridium Operating LLC, 478 F.3d 452, 462 (2d Cir. 2007) (internal citations omitted). Although several of these factors were developed by courts in the plan settlement context, they also apply outside the plan context in certain instances. 698 A related but different issue arises when the proposed settlement “has the effect of dictating the terms of a prospective chapter 11 plan.” In re Capmark Fin. Grp. Inc., 438 B.R. 471, 513 (Bankr. D. Del. 2010). In those instances, courts may deny approval of the settlement because it constitutes an impermissible sub rosa plan. See generally, Craig A. Sloane, The Sub Rosa Plan of Reorganization: Side-Stepping Creditor Protections in Chapter 11, 16 Bankr. Dev. J. 37 (1999). 699 See Section VI.F.4, Settlements and Compromises in Plan. 700 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model.  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 191 of 402 ABI Commission to Study the Reform of Chapter  should have an opportunity to review the terms of the proposed settlement. The settlement or compromise also should be subject to court approval. The Commissioners discussed the soundness of the notice and hearing process required by Bankruptcy Rule 9019, but acknowledged the discretion given the trustee in presenting the settlement, and the court in approving or denying the settlement. Beyond requiring notice and a hearing, Bankruptcy Rule 9019 establishes no parameters for the content or timing of settlements. It also does not set forth a standard or criteria for the assessment of settlements. The Commission agreed that codifying the settlement approval process, including an appropriate standard of review, would further facilitate the bankruptcy policy of encouraging consensual resolution of disputed matters. The Commission reviewed the courts’ various approaches to assessing proposed settlements and compromises under Bankruptcy Rule 9019. This review identified a wide range of approaches, from “the lowest point of reasonableness” to the “fair and equitable” standard used to evaluate compromises and plans under the Bankruptcy Act. The Commissioners generally agreed that the lowest point of reasonableness standard did not sufficiently scrutinize the terms of the proposed settlement and its impact on the estate. Several Commissioners suggested using the fair and equitable standard as applied by the U.S. Supreme Court in TMT Trailer Ferry.701 Other Commissioners expressed concern regarding the ambiguity surrounding “fair and equitable” and its common association with approval of a chapter 11 plan in the cramdown context.702 The Commissioners generally agreed 6 that something less than fair and equitable, but still meaningful, should201 1, govern the approval of ber 2 ovem settlements and compromises. on N ived arch 363 -35 After discussing different approaches, ,the .Commission agreed to use a hybrid standard that requires o 14 n N w the settlement or compromise v. Bro “reasonable and in the best interests of the estate.” It favored this th to be lixse in B standard becauseitedwould adequately protect the estate and allow the court to weigh the evidence c it presented on the particular settlement or compromise. Although the Commission believed that the proposed “reasonable and in the best interests of the estate standard” is better suited than a “fair and equitable” standard for the review and approval of settlements and compromises, it also believed that courts should still engage in a totality of the circumstances analysis that considers factors such as those articulated by courts under the fair and equitable approach.703 701 Protective Comm. for Indep. Stockholders of TMT Trailer Ferry, Inc. v. Anderson, 390 U.S. 414, 424–25 (1968). 702 The fair and equitable standard is used in the cramdown context under section 1129 of the Bankruptcy Code. The Bankruptcy Code also incorporates elements necessary to make a plan fair and equitable to any particular class of creditors or equity securities holders that reject the plan. 703 See, e.g., Protective Comm. for Indep. Stockholders of TMT Trailer Ferry, Inc. v. Anderson, 390 U.S. 414, 424–25 (1968) (“[T]he judge should form an educated estimate of the complexity, expense, and likely duration of such litigation, the possible difficulties of collecting on any judgment which might be obtained, and all other factors relevant to a full and fair assessment of the wisdom of the proposed compromise.”). V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 192 of 402 Bankruptcy Institute H. The In Pari Delicto Doctrine Recommended Principles: The in pari delicto defense should be inapplicable to claims for relief that a trustee appointed under section 1104 in the chapter 11 case asserts against third parties under section 541 of the Bankruptcy Code. The absence of the in pari delicto defense should not otherwise affect the trustee’s burden to establish the claims for relief under applicable law. The Commission was unable to reach a consensus on eliminating the in pari delicto defense with respect to claims for relief that other estate fiduciaries or parties authorized to act on behalf of the estate (e.g., litigation trustees, postconfirmation entities, unsecured creditors’ committees, debtors in possession) might assert against third parties under the Bankruptcy Code. The In Pari Delicto Doctrine: Background The Latin phrase in pari delicto means “in equal fault,”704 and the in pari delicto 016 doctrine generally 1, 2 bars the pursuit of a cause of action by a plaintiff who allegedly actedoveconcert with the defendants, in mber 2 N d on or was otherwise involved, in the wrongful conduct underlying the plaintiff ’s complaint. The in pari chive ar delicto doctrine is “grounded on two premises:1first,363 courts should not lend their good offices 35 that . 4, No to mediating disputes among wrongdoers; and second, that denying judicial relief to an admitted own v. Br eth wrongdoer is an effective imeans of deterring illegality.”705 The in pari delicto issue arises in a variety Blixs ed n cit of instances in chapter 11 cases, but perhaps most commonly in cases precipitated by a prepetition Ponzi scheme.706 In many cases, the underlying cause of action is grounded in prepetition conduct and belongs to the estate under section 541 of the Bankruptcy Code. The target defendant might be an accountant, auditor, attorney, bank, broker, insider, or others. The state law claim might be aiding and abetting fraud, breach of fiduciary duty, negligence, malpractice, aiding and abetting breach of fiduciary duty, negligent misrepresentation, negligent supervision, or conspiracy. Among the defendant’s affirmative defenses is in pari delicto. Under present law, because the debtor’s wrongdoing would bar any recovery by the debtor, the trustee is likewise entitled to no relief. Every circuit except the Ninth Circuit has ruled on the issue and has held that, under section 541, the in pari delicto doctrine bars a trustee’s claims when the doctrine would bar the claims if brought by the debtor.707 704 See, e.g., Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 306 (1985). 705 Mosier v. Callister, Nebeker & McCullough PC, 546 F.3d 1271, 1275 (10th Cir. 2008). 706 In the context of reviewing fraudulent transfer law under section 548 of the Bankruptcy Code, the Commission considered codifying the “Ponzi scheme presumption,” which would basically create a rebuttable presumption that transfers made in furtherance of a Ponzi scheme are fraudulent transfers subject to avoidance. See, e.g., In re Manhattan Inv. Fund Ltd., 397 B.R. 1, 11–13 (S.D.N.Y. 2007). The term “Ponzi scheme” is not well defined under the case law. Id. After much deliberation, the Commission decided that this issue was best left to further development under the case law. 707 See, e.g., Peterson v. McGladrey & Pullen, LLP (In re Lancelot Investors Fund, L.P.), 676 F.3d 594 (7th Cir. 2012); Gray v. Evercore Restructuring L.L.C., 544 F.3d 320, 324–25 (5th Cir. 2008); Mosier v. Callister, Nebeker & McCullough, 546 F.3d 1271, 1276 (10th Cir. 2008); Baena v. KPMG LLP, 453 F.3d 1, 6 (1st Cir. 2006); Nisselson v. Lernout, 469 F.3d 143, 153 (1st Cir. 2006), cert. denied, 550 U.S. 918 (2007); Official Comm. of Unsecured Creditors of PSA, Inc. v. Edwards, 437 F.3d 1145, 1149–56 (11th Cir.  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 193 of 402 ABI Commission to Study the Reform of Chapter  Courts have recognized certain exceptions to the application of the in pari delicto doctrine. For example, the “adverse interest” exception provides that if the officers and directors of the debtor who participated in the fraudulent transactions were acting in their own interests and to the detriment of the debtor, then the adverse interest exception defeats the in pari delicto doctrine.708 Another exception, known as the “innocent decision maker” exception, may apply if not all of the “shareholders or decision makers are involved in the fraud” — i.e., there was at least one innocent insider to whom the defendant could have reported their findings.709 Some courts have found the innocent decision maker exception inapplicable, however, when an innocent member of management “could and would have prevented the fraud had they been aware of it.”710 In addition, the in pari delicto doctrine applies only to a trustee’s claims under section  541. Accordingly, courts have determined that the doctrine should not apply to, for example, the trustee’s “strong arm” claims under section 544;711 preference claims under section 547;712 and fraudulent transfer claims under section 548.713 Despite the various exceptions, the in pari delicto doctrine may preclude the trustee from pursuing causes of action that benefit the estate and the beneficiaries of the estate who are innocent victims as to the underlying cause of action. Several commentators thus have questioned the relevance and fairness of applying the in pari delicto doctrine in bankruptcy cases. These commentators note, among other things, that state and federal law receivers generally are not subject to the in pari delicto 6 defense.714 The question persists whether trustees in bankruptcy should, 201 the same ability to 1 have ber 2 m pursue actions against third parties to the same extent as anstateelaw receiver (or a receiver under Nov ed o chiv the Federal Depository Insurance Act or the federal rsecurities laws), or whether trustees should be 63 a -353 . 14 treated differently, given the bankruptcyomaxim that a trustee stands in the shoes of the debtor and ,N rown B is subject to the same defensesvas the debtor.715 h . xset i in Bl cited 708 709 710 711 712 713 714 715 2006), cert. denied, 549 U.S. 811 (2006); Grassmueck v. Am. Shorthorn Ass’n, 402 F.3d 833, 836–37 (8th Cir. 2005); Logan v. JKV Real Estate Servs. (In re Bogdan), 414 F.3d 507, 514–15 (4th Cir. 2005), cert. denied, 546 U.S. 1093 (2006) (noting exception where claims have been assigned to trustee); Official Comm. of Unsecured Creditors of Color Tile, Inc., v. Coopers & Lybrand, LLP, 322 F.3d 147, 158 (2d Cir. 2003); Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., Inc., 267 F.3d 340, 354–60 (3d Cir. 2001); Terlecky v. Hurd (In re Dublin Sec., Inc.), 133 F.3d 377, 380 (6th Cir. 1997), cert. denied, 525 U.S. 812 (1998); Sender v. Buchanan (In re Hedged-Invs. Assocs., Inc.), 84 F.3d 1281, 1284–86 (10th Cir. 1996); Hirsch v. Arthur Andersen & Co., 72 F.3d 1085, 1094–95 (2d Cir. 1995); Shearson Lehman Hutton, Inc. v. Wagoner, 944 F.2d 114, 118–20 (2d Cir. 1991). But see USACM Liquidating Trust v. Deloitte & Touche, 754 F.3d 645, 649 (9th Cir. 2014), aff ’g 764 F. Supp. 2d 1210, 1229 (D. Nev. 2011). Notably, the Second Circuit appears to treat the issue not as a defense like the other circuits, but as an issue of standing. See Breeden v. Kirkpatrick & Lockhart LLP (In re Bennett Funding Grp., Inc.), 336 F.3d 94, 100 (2d Cir. 2003); Hirsch v. Arthur Andersen & Co., 72 F.3d 1085, 1094–95 (2d Cir. 1995); Shearson Lehman Hutton, Inc. v. Wagoner, 944 F.2d 114, 118 (2d Cir. 1991). Bankruptcy Servs., Inc. v. Ernst & Young (In re CBI Holding Co., Inc.), 529 F.3d 432 (2d Cir. 2008). Importantly, there are variations on the adverse interest exception. For example, some courts narrowly interpret the exception to apply when the guilty manager has “totally abandoned” the interest of the principal corporation, while other courts engage in an analysis of the respective benefits received by the corporate entity and the wrongdoer insider, Thabault v. Chait, 541 F.3d 512, 527 (3d Cir. 2008); Baena v. KPMG, LLP, 453 F.3d 1, 8 (1st Cir. 2006); Breeden v. Kirkpatrick & Lockhard LLP (In re Bennett Funding Grp.), 336 F.3d 94, 100 (2d Cir. 2003). Other courts have found that the adverse interest exception should be determined by the agent’s subjective motives, rather than by a strict rule of whether the debtor received any benefit as a result of the agent’s activities, Bankruptcy Servs. Inc. v. Ernst & Young (In re CBI Holding Co., Inc.), 529 F.3d 432, 451 (2d Cir. 2008). Smith v. Andersen L.L.P., 175 F. Supp. 2d 1180, 1199 (D. Ariz. 2001); Breeden v. Kirkpatrick & Lockhart, LLP, 268 B.R. 704, 710 (S.D.N.Y. 2001), aff ’d, In re Bennett Funding Group, Inc., 336 F.3d 94 (2d Cir. 2003); SIPC v. BDO Seidman, LLP, 49 F. Supp. 2d 644, 650 (S.D.N.Y. 1999), aff ’d in part, 222 F.3d 63 (2d Cir. 2000). See, e.g., In re CBI Holding Co., Inc., 311 B.R. 350, 372 (S.D.N.Y. 2004), aff ’d in part, rev’d in part, 529 F.3d 432 (2d Cir. 2008). Kaliner v. MDC Sys. Corp., LLC, 2011 U.S. Dist. LEXIS 5377, at *15 (E.D. Pa. Jan. 20, 2011). See, e.g., In re CBI Holding, Inc., 311 B.R. 350, 372 (S.D.N.Y. 2004), aff ’d in part, rev’d in part, 529 F.3d 432 (2d Cir. 2008). McNamara v. PFS (In re Pers. & Bus. Ins. Agency), 334 F.3d 239, 245–47 (3d Cir. 2003). See FDIC v. O’Melveny & Myers, 61 F.3d 17, 18–19 (9th Cir. 1995); Scholes v. Lehmann, 56 F.3d 750, 754–55 (7th Cir. 1995), cert. denied, 516 U.S. 1028 (1995); Goldberg v. Chong, 2007 U.S. Dist. LEXIS 49980, *28–29 (S.D. Fla. July 11, 2007). Some courts follow the bankruptcy analogy and conclude that because the receiver simply steps into the shoes of the receivership entity in pursuing the entity’s claims, and because the in pari delicto doctrine would bar the entity’s claim, it bars the receiver’s claim. See, e.g., Wuliger v. Mfrs. Life Ins. Co., 567 F.3d 787, 792 (6th Cir. 2009); Knauer v. Jonathon Roberts Fin. Grp., Inc., V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 194 of 402 Bankruptcy Institute The In Pari Delicto Doctrine: Recommendations and Findings The in pari delicto doctrine’s application to certain of a trustee’s or other estate representative’s claims against third parties in a bankruptcy case is subject to much debate in the literature. The conclusion that parties cannot assert the in pari delicto defense against claims that are available only to the trustee in a bankruptcy case — such as preference claims and fraudulent conveyance claims — is well supported. A debtor has no rights in, or ability to pursue, such claims, and the trustee does not stand in the shoes of the debtor for purposes of those actions. Prepetition claims of the debtor that become property of the estate under section 541 of the Bankruptcy Code may, however, require a different analysis. The Commission considered current trends in the case law on the in pari delicto doctrine, the underlying justifications for the doctrine, and whether a trustee or estate representative should be subject to the in pari delicto defense in bankruptcy, irrespective of the genesis of the claims. The Commission reviewed the primary purposes of the in pari delicto doctrine, most commonly articulated as follows: that “courts should not lend their good offices to mediating disputes among wrongdoers” and “denying judicial relief to an admitted wrongdoer is an effective means of deterring illegality.”716 The Commissioners generally agreed that the doctrine served these basic goals when applied outside of bankruptcy: a company that participated in a wrong should not be able to benefit from that wrong. For some of the Commissioners, however, the intervention of a bankruptcy case changed the calculus dramatically. 16 1, 20 ber 2 may bring the action In bankruptcy, a party not involved with the alleged prepetition wrongdoing vem n No ed o That party typically is the trustee, for the benefit of the estate (e.g., innocent creditors of therdebtor). chiv 63 a -353 or other estate representative. The trustee, unsecured creditors’ committee, litigationNo. 14 trustee, , rown trustee, or other estate representative did not participate unsecured creditors’ committee, tlitigation v. B se h in the wrong and is not d in Blix recoveries that would benefit any of the wrongdoers. Indeed, to the seeking cite extent that the debtor’s prepetition shareholders, officers, or directors who may have been involved with the alleged wrongdoing are creditors of the estate, those claimants can be barred from receiving any recoveries from the litigation. Several of the Commissioners found the case for not allowing third parties to assert the in pari delicto defense against the trustee or other estate representative very compelling. These Commissioners 348 F.3d 230, 236 (7th Cir. 2003); In re Wiand, 2007 WL 963165, at *6–7 (M.D. Fla. Mar. 27, 2007). Other courts conclude that because the receiver’s role is to protect innocent investors, and because these investors were not complicit in the fraud, the in pari delicto doctrine does not bar the receiver’s claim. See, e.g., Jones v. Wells Fargo Bank, N.A., 666 F.3d 955, 966 (5th Cir. 2012) (“A receiver is ‘the representative and protector of the interests of all persons, including creditors, shareholders and others, in the property of the receivership.’ . . . The receiver has a duty to pursue a corporation’s claims.’ . . . Although a receiver generally ‘has no greater powers than the corporation had as of the date of the receivership,’ it is well established that ‘when the receiver acts to protect innocent creditors . . . he can maintain and defend actions done in fraud of creditors even though the corporation would not be permitted to do so.’ . . . The receiver thus acts on behalf of the corporation as a whole, an entity separate from its individual bad actors.”) (citations omitted); FDIC v. O’Melveny & Myers, 61 F.3d 17, 19 (9th Cir. 1995) (“A receiver, like a bankruptcy trustee and unlike a normal successor in interest, does not voluntarily step into the shoes of the bank; it is thrust into those shoes. It was neither a party to the original inequitable conduct nor is it in a position to take action prior to assuming the bank’s assets to cure any associated defects or force the bank to pay for incurable defects. This places the receiver in stark contrast to the normal successor in interest who voluntarily purchases a bank or its assets and can adjust the purchase price for the diminished value of the bank’s assets due to their associated equitable defenses. In such cases, the bank receives less consideration for its assets because of its inequitable conduct, thus bearing the cost of its own wrong.”); Javitch v. Transamerica Occidental Life Ins. Co., 408 F. Supp. 2d 531, 538 (N.D. Ohio 2006) (“An equity receiver’s duties are fashioned and may be modified by the appointing court. Because this Court has expressly given the Receiver’s broad authority to pursue claims on behalf of Liberte and the investors, the Receiver is not precluded from these actions under the doctrine of in pari delicto.”); Isp.com LLC v. Theising, 805 N.E.2d 767, 773 (Ind. 2004) (“The receiver is in some respects a new entity, untainted by the corporation’s wrongdoing. He is not necessarily barred by in pari delicto.”). 716 Official Comm. of Unsecured Creditors of PSA Inc. v. Edwards, 437 F.3d 1145 (11th Cir. 2006), cert. denied, 549 U.S. 811 (2006).  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 195 of 402 ABI Commission to Study the Reform of Chapter  emphasized the distinction between the prepetition debtor company and a trustee or litigation trust for purposes of the defense. They posited that the justifications for the in pari delicto doctrine, as articulated above, simply did not apply in the trustee context. In fact, they noted that innocent creditors actually were being penalized because, outside of bankruptcy: (i)  state law receivers and receivers appointed by the Securities and Exchange Commission or the Federal Depository Insurance Company could pursue claims previously belonging to the alleged company wrongdoer and not be subject to the defense;717 and (ii) individual creditors harmed by the wrong could sue the third parties without being subject to the defense.718 The Commissioners supporting elimination of the in pari delicto defense in bankruptcy viewed its enforcement as penalizing the debtor’s innocent creditors, who likely were already suffering losses as a result of the bankruptcy itself. The Commissioners parsed through the likely practical implications of eliminating the in pari delicto defense in bankruptcy. The Commissioners acknowledged that including the debtor in possession in the concept of an “estate representative” not subject to the in pari delicto defense may raise closer policy issues. Although the debtor in possession has a legal status different from the prepetition debtor under the Bankruptcy Code, the Commissioners acknowledged that the debtor in possession could still employ some of the individuals who allegedly participated on behalf of the debtor in the wrongdoing. They also presented a closer conceptual question on the policy issues. Some of the Commissioners supported including the debtor in possession among the estate representatives that should not be subject to the in pari delicto defense.719 Some of the Commissioners believed it 16 was more important to eliminate the defense, at least as to bankruptcy 21, 20 and then also as to trustees, ber m unsecured creditors’ committees, litigation trustees, and similar ve n Noestate representatives that were not ed o iv arch affiliated with the prepetition debtor. 5363 -3 o. 14 n, N row Commissioners voiced v. B th concern that any change to the current law essentially would create lixse in B cause of action for the estate not otherwise available under state law. These Commissioners cited Other a new focused on the fact that the debtor (or an entity acting on behalf of the debtor) generally could not pursue such claims under nonbankruptcy law, unless a receiver was appointed.720 They believed that eliminating the in pari delicto defense in bankruptcy directly conflicted with the long-standing principle that bankruptcy does not enhance a debtor’s rights in property.721 From that principle flow the equally important concepts that the estate’s interest in property is limited to that held by the debtor prepetition, and that the trustee steps into the debtor’s shoes with respect to those property interests and is subject to any defenses otherwise applicable against the debtor.722 These Commissioners could 717 O’Melveny & Myers v. FDIC, 512 U.S. 79 (1994) (remanding on grounds that state law should determine if defense applies). On remand, the Ninth Circuit held that the defense did not apply to receiver even under California law. FDIC v. O’Melveny & Myers, 61 F.3d 17 (9th Cir. 1995). See also Scholes v. Lehmann, 56 F.3d 750, 754 (7th Cir. 1995), cert. denied, 516 U.S. 1028 (1995) (“Put differently, the defense of in pari delicto loses its sting when the person who is in pari delicto is eliminated.”). 718 FDIC v. O’Melveny & Myers, 61 F.3d 17, 19 (9th Cir. 1995) (“While a party may itself be denied a right or defense on account of its misdeeds, there is little reason to impose the same punishment on a trustee, receiver or similar innocent entity that steps into the party’s shoes pursuant to court order or operation of law. Moreover, when a party is denied a defense under such circumstances, the opposing party enjoys a windfall. This is justifiable as against the wrongdoer himself, not against the wrongdoer’s innocent creditors.”). 719 These Commissioners noted that, in most cases, management of the old debtor has been replaced or a Chief Restructuring Officer has been appointed. 720 These Commissioners noted that the receiver context was different than the collective action process of bankruptcy and believed that the different treatment was justified on that basis. 721 See, e.g., S. Rep. No. 95-989, at 82 (1978), reprinted in 1978 U.S.C.C.A.N. 5787; H.R. Rep. No. 95-595, at 367–68 (1977), reprinted in 1978 U.S.C.C.A.N. 5963 (explaining that section 541 cannot “expand the debtor’s rights against others more than they exist at the commencement of the case”). 722 See, e.g., McNamara v. PFS (In re Personal & Bus. Ins. Agency), 334 F.3d 239, 245 (3d Cir. 2003) (“[I]n actions brought by the trustee as successor to the debtor’s interest under section 541, the ‘trustee stands in the shoes of the debtor and can only assert those causes of action possessed by the debtor. [Conversely,] the trustee is, of course, subject to the same defenses as could have V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 196 of 402 Bankruptcy Institute not reconcile these principles with the elimination of the in pari delicto defense. They also pointed to the inherent unfairness of allowing the principal wrongdoer, or someone standing in the shoes of the wrongdoer, to prosecute a claim against a party who may have been negligent when the wrongdoer’s conduct was intentional (i.e., the defendant is liable to the plaintiff because it negligently failed to detect the plaintiff ’s intentionally concealed fraud). These Commissioners objected not only to eliminating the defense as to a debtor in possession but also as to the trustee and any other estate representative. They argued that it would be bad policy to allow an estate representative to pursue professionals and institutions on claims that may lack merit and for which one of the alleged wrongdoers — the debtor — is not subject to collection actions. They suggested that such a proposal would encourage “shakedowns” and unfounded settlements because defendants would be forced to settle (regardless of merit) to avoid the risk of potentially significant liability. They likewise noted that eliminating the defense could skew incentives and create unintended challenges for professionals in the distressed industry. The Commissioners supporting the elimination of the in pari delicto defense in bankruptcy focused on the parties represented by the trustee in bankruptcy — e.g., typically general unsecured creditors. They repeatedly emphasized that these creditors are innocent in the process and generally harmed by the types of wrongful conduct alleged in lawsuits in which third parties may assert the in pari delicto defense. They suggested that eliminating just the in pari delicto defense and preserving a 6 defendant’s other defenses would strike the appropriate balance between er 21bankruptcy policy of the , 201 b allowing an estate representative to pursue claims to maximize the Novemof the estate for the benefit value d on chive of creditors and allowing parties to appropriately defend rthemselves in unfounded litigation. From 3a 3536 . 14- in pari delicto defense against the bankruptcy this perspective, allowing defendants to n, No the assert Brow v. creditors) at a significant disadvantage and provide defendants trustee would place the trustees(and eth Blix with a shield that theyitwould not be able to use under state or federal receivership law. ed in c The Commission explored several alternatives for bridging the disparate views of the Commissioners on this issue. Some of the Commissioners suggested a compromise of a federal comparative default rule for these actions, wherein the in pari delicto defense would not be available, but defendants could assert that the debtor or its management was primarily at fault. Others suggested modifications to this proposal that would allow defendants to assert that they should not be liable because they were not primarily at fault (i.e., the debtor or another defendant was primarily at fault). The Commissioners expressed concern that this approach would only result in finger-pointing and not serve the purpose of compensating the estate and creditors for prepetition wrongs against their interests. The Commission then attempted to identify areas of agreement to build consensus on this issue. First, the Commissioners discussed allowing individual creditors to pursue claims that they in fact hold under applicable nonbankruptcy law against third parties allegedly acting in concert with the prepetition debtor free of the in pari delicto defense (which would not be applicable in any event) in the bankruptcy case. The Commissioners were generally comfortable with this approach, been asserted by the defendant had the action been instituted by the debtor.’”) (quoting Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340, 356 (3d Cir. 2001)); Hirsch v. Arthur Andersen & Co., 72 F.3d 1085, 1093 (2d Cir. 1995) (“[T] he trustee stands in the shoes of the debtors, and can only maintain those actions that the debtors could have brought prior to the bankruptcy proceedings.”).  V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 197 of 402 ABI Commission to Study the Reform of Chapter  provided that any recoveries were available only to those creditors holding the claims. Second, the Commissioners discussed allowing a creditor or creditors to pursue such claims in the bankruptcy case on behalf of all creditors when a generalized harm existed. The Commission was fairly evenly split on this component, with some arguing that, in substance, it was no different than allowing an estate representative to bring the claim free of the in pari delicto defense. After extensive deliberation, the Commission recommended the elimination of the in pari delicto defense solely with respect to any trustee appointed in the chapter 11 case. The Commission determined that this modification would provide the trustee with rights similar to those possessed by receivers in other contexts, and it would not expose defendants to claims brought by a party controlled or influenced by alleged wrongdoers (e.g., directors, officers, or employees of the debtor). The Commission viewed this as an extension of the potential liability of defendants outside of bankruptcy, where creditors (or a receiver on behalf of creditors) could assert claims not subject to the in pari delicto defense, and not as a significant expansion of the trustee’s powers against the defendants in bankruptcy. The Commission did not reach a position with respect to the availability of the in pari delicto defense in actions brought by other estate representatives, the debtor in possession, or unsecured creditors’ committees. Accordingly, the Commission is not making a proposal on the in pari delicto defense in actions brought by those entities in the chapter 11 case. in cited 16 1, 20 ber 2 vem n No ed o rchiv 63 a -353 . 14 , No rown .B eth v Blixs V. Proposed Recommendations: Administering the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 198 of 402 Bankruptcy Institute in cited  16 1, 20 ber 2 vem n No ed o rchiv 63 a -353 . 14 , No rown .B eth v Blixs V. Proposed Recommendations: Administering the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 199 of 402 16 1, 20 ber 2 vem n No ed o rchiv 63 a -353 . 14 , No rown .B eth v Blixs VI. PROPOSED RECOMMENDATIONS: EXITING THE CASE in cited AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 200 of 402 Bankruptcy Institute A. General Authority of Debtor in Possession and Its Board of Directors 1. Preemption and the Authority to Approve Transactions and Plan Recommended Principles: A debtor in possession’s board of directors or similar governing body should be able to act on behalf of the debtor in possession in the chapter 11 case without seeking or obtaining approval of the debtor’s equity security holders, including with respect to transactions under section 363 of the Bankruptcy Code. Accordingly, the Bankruptcy Code should preempt any applicable state entity governance law on these matters, and section 1107 should be amended. An order of the court confirming a plan under section 1129 of the Bankruptcy Code should govern the implementation of all transactions contemplated by the plan in accordance with section 1123(a)(5) and preempt any applicable nonbankruptcy 016 law. Sections 1141 and 1142 should be amended to clarify this ber 21, 2 point. m ve n No ed o The preemptive effect of the chapter 11 plan,hiconfirmation order, or section rc v 63 a -353 included therein should not relieve 14 363x sale order with respect to ,transactions No. rown the directors, officers,thor B v. similar managing persons of the debtor, debtor in xse n Bli i possession, itor reorganized debtor of their fiduciary duties under applicable state c ed entity governance law in implementing or affecting any transactions under the plan or sale order. Preemption and the Authority to Approve Transactions and Plan: Background In general, the Bankruptcy Code defers to state law governance principles with respect to the fiduciary duties of a debtor in possession’s723 governing body, whether a board of directors, board of managers, or similar concentrated management structure, as well as its directors, officers, or similar managing persons.724 As discussed above, this deference generally means that those individuals or entities owe the duties of care and loyalty, and an obligation of good faith.725 These state law duties and obligations govern the conduct of those individuals or entities in operating the business and managing its affairs. In addition, state or other applicable nonbankruptcy law may require the debtor 723 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. 724 See, e.g., David A. Skeel, Rethinking the Line Between Corporate Law and Corporate Bankruptcy, 72 Tex. L. Rev. 471, 491 (1994) (explaining tradition deference to state governance law). See also Fogel v. U.S. Energy Sys., Inc., 2008 WL 151857, at *1 (Del. Ch. Jan. 15, 2008) (“[C]orporate governance does not cease when a company files a petition under Chapter 11 and that issues of corporate governance are best left to the courts of the state of incorporation.”). 725 See Section IV.A.1, The Debtor in Possession Model.  VI. Proposed Recommendations: Exiting the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 201 of 402 ABI Commission to Study the Reform of Chapter  in possession or its governing body to obtain approvals or satisfy specified conditions before taking certain actions for, or on behalf of, the debtor. For example, state law or the debtor’s charter may require the debtor’s board of directors to obtain the approval of shareholders before selling all or substantially all of the debtor’s assets.726 State law also may require the board of directors to hold an annual shareholders meeting. Although courts commonly allow a debtor in possession to sell all or substantially all of its assets under section 363(b) of the Bankruptcy Code without seeking or obtaining shareholder approval, courts have taken a different approach to the shareholders meeting requirement. Most courts review a demand on the debtor in possession to hold the annual shareholders meeting under a “clear abuse” standard, which considers whether the shareholders’ rights to vote for directors “and thus to control corporate policy . . . will not be disturbed unless a clear case of abuse is made out.”727 Some courts have, however, enjoined the shareholders meeting or denied a shareholder’s request to compel the meeting when the strategic objectives of the requesting shareholders are determined to be adverse to the interests of the estate.728 Additionally, a debtor’s chapter 11 plan will likely propose a new capital structure and new board members or managers, and it may propose a merger or other change in control transaction, as well as other various actions required or permitted by section 1123 of the Bankruptcy Code. Section 1123(a)(5) specifically provides: 2016 r 21 (a) Notwithstanding any otherwise applicable nonbankruptcyelaw,, a plan shall — mb ve n No ed o ... iv arch 363 -35plan’s implementation, such as — . 4 (5) provide adequate meansNfor1the , o rown v. B (A) retentionhby the debtor of all or any part of the property of the xset n Bli i cited estate; (B) transfer of all or any part of the property of the estate to one or more entities, whether organized before or after the confirmation of such plan; (C) merger or consolidation of the debtor with one or more persons; (D) sale of all or any part of the property of the estate, either subject to or free of any lien, or the distribution of all or any part of the property of the estate among those having an interest in such property of the estate; (E) satisfaction or modification of any lien; (F) cancellation or modification of any indenture or similar instrument; (G) curing or waiving of any default; 726 See Esopus Creek Value LP v. Hauf, 913 A.2d 593, 596, 605–06 (Del. Ch. 2006). See also Del. Code Ann. tit. 8, § 271(a) (2008) (requiring a majority of shareholders to approve the sale of all or substantially all of a corporation’s property and assets). 727 Fogel v. U.S. Energy Sys., Inc., 2008 WL 151857, at *1 (Del. Ch. Jan. 15, 2008) (citing In re Lionel Corp., 30 B.R. 327, 329–30 (Bankr. S.D.N.Y. 1983)). 728 See, e.g., Manville Corp. v. Equity Sec. Holders Comm. (In re Johns-Manville Corp.), 801 F.2d 60 (2d Cir. 1986) (discussing court’s ability to limit shareholders’ rights during chapter 11 case). VI. Proposed Recommendations: Exiting the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 202 of 402 Bankruptcy Institute (H) extension of a maturity date or a change in an interest rate or other term of outstanding securities; (I) amendment of the debtor’s charter; or (J) issuance of securities of the debtor, or of any entity referred to in subparagraph (B) or (C) of this paragraph, for cash, for property, for existing securities, or in exchange for claims or interests, or for any other appropriate purpose;729 The legislative history of section 1123(a)(5) provides that the section is “intended to indicate that a plan may provide for any action specified in section 1123 in the case of a corporation without a resolution of the board of directors” and, if confirmed, “any action proposed in the plan may be taken notwithstanding any otherwise applicable nonbankruptcy law in accordance with section 1142(a) [of the Bankruptcy Code].”730 The phrase “[n]otwithstanding any otherwise applicable nonbankruptcy law” was added to section 1123 in 1984 to clarify the preemptive nature of the section. Nevertheless, the Ninth Circuit Court of Appeals has read section 1123(a)(5) narrowly to limit its preemptive effect to the scope of section 1142(a), which arguably is limited to “applicable nonbankruptcy law, rule, or regulation relating to financial condition.”731 Other courts have, however, declined to graft section 1142(a)’s limitation onto section 1123(a), noting that Congress used different language in section 1123(a), 016 though it was even 1, 2 732 ber 2 aware of section 1142(a)’s language at the time of the amendment. ovem N d on chive 3 ar 3536 . 14Preemption and the Authorityroton,Approve Transactions No w v. B Recommendations andixFindings eth Bl s ed in cit and Plan: State entity governance law continues to play an important role in the debtor’s operations postpetition and postconfirmation. In light of the Bankruptcy Clause of the U.S. Constitution733 and well-established principles of federal preemption, however, there are instances in which state entity governance law and other related law must yield to the Bankruptcy Code. The Commission endeavored to clarify these boundaries and better articulate the debtor in possession’s ability to transact business during the chapter 11 case. The Commissioners discussed areas of the federal bankruptcy law and state entity governance law that might conflict, focusing on sale transactions, plan implementation, and equity security holders 729 11 U.S.C. § 1123(a)(5). See also 7 Collier on Bankruptcy ¶ 1123.01[5] (16th ed. 2009) (“The types of means listed in section 1123(a)(5) are clearly illustrative and not exclusive.”). 730 Section 1142(a) provides: “Notwithstanding any otherwise applicable nonbankruptcy law, rule, or regulation relating to financial condition, the debtor and any entity organized or to be organized for the purpose of carrying out the plan shall carry out the plan and shall comply with any orders of the court.” 11 U.S.C. § 1142(a). 731 In re Pac. Gas & Elec. Co. v. Cal. Dep’t of Toxic Substances Control, 350 F.3d 932, 949 (9th Cir. 2003), cert. denied, 543 U.S. 956 (2004). 732 In re Renegade Holdings, Inc., 429 B.R. 502 (Bankr. M.D.N.C. 2010) (declining to follow Pacific Gas). See also In re FederalMogul Global Inc., 684 F.3d 355 (3d Cir. 2012) (same); In re FCX, Inc., 853 F.2d 1149, 1155 (4th Cir. 1988), cert. denied, 489 U.S. 1011 (1989) (holding that section 1123(a)(5) is an “empowering statute” that “does not simply provide a means to exercise the debtor’s pre-Bankruptcy rights; it enlarges the scope of those rights”); In re Stone & Webster, Inc., 286 B.R. 532, 543 (Bankr. D. Del. 2002) (explaining that “the provisions of a plan as articulated in § 1123(a) can be effected without regard to otherwise applicable nonbankruptcy law, including the corporation law of the State of Delaware or any other state corporation laws having bearing on the debtors”). 733 U.S. Const. art. I, § 8, cl.4.  VI. Proposed Recommendations: Exiting the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 203 of 402 ABI Commission to Study the Reform of Chapter  meetings. The Commissioners found that courts generally allow debtors in possession to proceed with section 363 sales of all or substantially of its assets without any equity security holder approval under applicable state law or the debtor’s organizational documents. The Commissioners discussed the protections for stakeholders provided by the Bankruptcy Code in the sale context, including the new principles proposed for section 363x sales. They also considered the delay and uncertainty introduced into the process by requiring an equity security holders’ vote, the fact that equity security holders are often out of the money in these cases, and the ability of equity security holders to object or otherwise be heard on the proposed sale under sections 1109 and 363 of the Bankruptcy Code. The Commission agreed that the Bankruptcy Code should be amended to clarify the ability of the board of directors or similar governing body to pursue and consummate section 363 transactions without approvals required by state entity governance law, including an equity security holders’ vote. The Commissioners also discussed the different approaches of courts to a debtor in possession’s obligations under state law to hold annual or special shareholders’ meetings. The Commissioners recognized that complying with an annual meeting requirement, or responding to a shareholder’s request for a special meeting, may impose costs on the estate and delay the case. They did not believe, however, that a general prohibition on shareholders’ meetings during chapter 11 cases was an appropriate response. When the debtor acting as such for the benefit of its shareholders (as opposed to the debtor in possession acting as representative of the estate; see next section) may propose a plan, it may be inappropriate to deny the shareholders the right to elect the directors who 16 1, that this issue was best are representing the shareholders’ interests. The Commission determined20 ber 2 m Nove resolved by courts under the current law and the facts of thenparticular case. do ive arch 363 -35 o. 14 In addition, the Commissioners discussed the interplay of bankruptcy law and applicable n, N ow v. Br nonbankruptcy law in thethcontext of transactions necessary to implement, or contemplated lixse B by, a chapter 11ited in The Commission reviewed the case law on the scope and application c plan. of section  1123(a), and along with 1984 amendment suggesting that Congress was expressly preempting nonbankruptcy law in that particular context. Indeed, “notwithstanding” is one of the most common indicators of expressed preemption, discarding any need to consider whether implied preemption was intended. The Commission considered whether there was a justification for linking the section 1123(a) preemption to the more limited preemption suggested in the section 1142(a) context. Notably, section 1123(a) speaks to matters necessary to obtain confirmation of the plan and to then implement the transactions, transfers, and distributions contemplated in the confirmed plan. The Commission agreed with those courts interpreting section  1123(a) as an empowering statute and recommended that sections 1141 and 1142 be amended to clarify the preemptive effect of that section. 2. Role of Debtor in Plan Process Recommended Principles: Section 1121 of the Bankruptcy Code should be amended to clarify that a debtor, in its capacity as such and as a plan proponent, is required to comply only with VI. Proposed Recommendations: Exiting the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 204 of 402 Bankruptcy Institute its fiduciary duties under applicable state entity governance law in negotiating, drafting, and seeking confirmation of a chapter 11 plan. Section 1121 should be amended to clarify that a debtor in possession’s board of directors, officers, or similar managing persons act as fiduciaries for the debtor in connection with the plan process (including, but not limited to, formulation, confirmation, and consummation of the plan), and applicable state law fiduciary duties should continue to govern their conduct.  In addition, to foster efficient and effective representation, professionals for the debtor in possession should be able to represent the debtor in possession in its capacity as an estate fiduciary and in its separate capacity as a debtor and plan proponent without violating section  327. Accordingly, section 327 should be amended to clarify this point. For a discussion of the fiduciary duties of the debtor in possession’s board of directors, officers, or similar managing persons, see Section IV.A.1, The Debtor in Possession Model. Role of Debtor in Plan Process: Background 16 1, 20 ber 2 vem n No When a company files a chapter 11 case, it assumes the role ofvdebtor in possession, which has certain ed o rchi 63 a rights, powers, and duties different from the prepetition debtor. Specifically, under section 1107 of -353 o. 14 the Bankruptcy Code, the debtor in Brown, N has the rights, powers, and duties of a bankruptcy possession h v. xse trustee. The debtor in possession tis also a fiduciary for the estate. Most provisions of the Bankruptcy n Bli i cited Code relevant to a chapter 11 case authorize the trustee, and in turn the debtor in possession, to take certain actions and exercise certain rights.734 Other provisions that require disclosures, impose obligations, or concern creditors’ rights in the case tend to apply to, or reference, the debtor. One important exception to this general categorical divide is section 1121 of the Bankruptcy Code, which provides that “[t]he debtor may file a plan with a petition commencing a voluntary case, or at any time in a voluntary case or an involuntary case.” Moreover, “only the debtor may file a plan until the 120 days after” the petition date. The legislative history of section 1121 focuses primarily on mitigating the practices under Chapter XI of the Bankruptcy Act that did not allow nondebtor parties to submit a plan of reorganization.735 Congress was concerned that complete exclusivity in the plan context might hold creditors hostage 734 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. 735 One court cited the legislative history of the Bankruptcy Act in support of creditor involvement: Within certain limits, the Chapter XI debtor can effectively dictate the essential ingredients of a Chapter XI plan to its creditors. In many cases, the alternative to creditors may be to accept the proverbial ‘ten cents on the dollar’ offered or be confronted with an adjudication in bankruptcy and the resultant liquidation. . . . The substantial loss that may be faced by creditors as a consequence of the forced auction sale of work in process, inventory, machinery and plant may be overwhelming. . . . The take-it-or-leave-it attitude on the part of debtors as permitted by Chapter XI is fraught with potential abuse. The granting of authority to creditors to propose plans of reorganization and rehabilitation serves to eliminate the potential harm and disadvantages to creditors [and] democratizes the reorganization process.  VI. Proposed Recommendations: Exiting the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 205 of 402 ABI Commission to Study the Reform of Chapter  and subject them to unfavorable treatment in the plan.736 Nevertheless, Congress recognized that the debtor was in the best position to serve as an honest broker and to negotiate a consensual plan. There is some suggestion that Congress was also concerned with providing appropriate incentives for prepetition management to invoke chapter 11 and to use the plan process to rehabilitate the debtor’s business. Although the company’s directors and officers remain the same whether it is serving as the debtor or the debtor in possession, the Bankruptcy Code arguably contemplates different roles for these two entities. Some courts interpret the language of the Bankruptcy Code as endorsing this approach, and they treat the debtor and the debtor’s fiduciary duties differently than those of the debtor in possession. For example, the court in In re Water’s Edge determined that the debtor in possession, acting as the debtor and plan proponent under sections 1121, 1127, 1129, 1141, and 1142, had no fiduciary duties to the estate.737 The court explained: A debtor in possession [as a debtor/plan proponent] is therefore permitted to place its own interests above those of the unsecured creditors with respect to what it proposes to pay under its plan. This is of course inconsistent with the concept that the debtor in possession is a fiduciary of the unsecured creditors owing them a duty of loyalty. The conclusion seems inescapable. As to its proposed plan dividend, a debtor in possession is not a fiduciary of the unsecured creditors owing them a duty of loyalty. Its bargaining and cramdown rights necessarily exclude such a fiduciary 16 1, 20 obligation.738 ber 2 em Nov d on chive 3 ar Other courts are imprecise in discussing the5debtor’s or debtor in possession’s roles in the plan 3 36 . 14, No process, and some have determinednthat the debtor in possession continues to owe duties to the ow v. Br estate in formulating and seth a plan. In addition, this confusion often spills over to the role and ix filing in Bl citedin possession’s professionals.739 duties of the debtor Role of Debtor in Plan Process: Recommendations and Findings Under section 1121 of the Bankruptcy Code, the debtor, as distinct from the debtor in possession, may file a chapter 11 plan. This distinction is important given the often competing and conflicting interests present in the bankruptcy estate and the challenges that a debtor would face if required In re Lake in the Woods, 10 B.R. 338, 344 (E.D. Mich. 1981) (quoting Bankr. Act Revision, Serial No. 27, Part 3, Hearings on H.R. 31 and H.R. 32 before the Subcomm. on Civil and Constitutional Rights of the Comm. on the Judiciary, 94th Cong., 2d Sess., at 1875–76 (Mar. 29, 1976) (statement of H. Miller, W. Rochelle and J. Trost)). 736 The Fifth Circuit explained the imbalance between debtors and their creditors that section 1121 was designed to mitigate: While we are not called upon here to decide what factors constitute “cause” for the extension of the exclusivity period, we think that any bankruptcy court involved in an assessment of whether “cause” exists should be mindful of the legislative goal behind Section 1121. The bankruptcy court must avoid reinstituting the imbalance between the debtor and its creditors that characterized proceedings under the old Chapter XI. Section 1121 was designed, and should be faithfully interpreted, to limit the delay that makes creditors the hostages of Chapter 11 debtors. United Sav. Ass’n v. Timbers of Inwood Forest Assocs., Ltd. (In re Timbers of Inwood Forest Assocs., Ltd.), 808 F.2d 363, 372 (5th Cir. 1987), aff ’d, 484 U.S. 365 (1988). 737 In re Water’s Edge Ltd. P’ship, 251 B.R. 1,7 (Bankr. D. Mass. 2000). 738 Id. at 8. 739 See, e.g., Hansen, Jones & Leta, P.C. v. Segal, 220 B.R. 434, 459–60 (D. Utah 1998). VI. Proposed Recommendations: Exiting the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 206 of 402 Bankruptcy Institute to negotiate and draft a chapter 11 plan that satisfied some fiduciary duty to these competing stakeholders.740 The Commission considered the continued utility of the distinction between the debtor and the debtor in possession in the plan process context. The Commissioners observed that the debtor as a plan proponent must consider the interests of the company and the company’s obligations to creditors and equity security holders in developing its chapter 11 plan. In this capacity, the debtor may be called upon to make difficult decisions concerning the business, its workforce, its assets, and its relationships with stakeholders. Although the debtor will negotiate with key stakeholders and attempt to achieve a consensus on its plan, it may not be able to start (or end) those negotiations with a plan structure that primarily benefits creditors alone. Moreover, what is in the best interests of creditors may not necessarily be in the best long-term interests of the company or its equity security holders in the plan context. The Commissioners analyzed whether it would be feasible for a debtor in possession to serve multiple masters by acting as a fiduciary for equity security holders and creditors in the plan process. The Commissioners discussed the potential conflicts of interests and competing objectives that could paralyze a debtor in possession acting in this dual role. A debtor in possession should not be placed in the position of negotiating a plan for the company and its equity security holders with the creditors whose interests the debtor in possession represents as a fiduciary of the estate. A party negotiating on behalf of different parties in the same deal rarely produces the best or a fair result. Accordingly, the 6 Commission agreed that the debtor should be separated from the debtor er 2possession in the plan in 1, 201 b em context, and that the debtor acting as plan proponent should not be vconsidered a fiduciary for the n No ed o iv arch creditors. 363 -35 o. 14 n, N Brow The Commissioners then discussed. what fiduciary duties, if any, the debtor’s directors, officers, or th v lixse similar managing personsin B cited should owe in the plan process. They reviewed a proposal by Stephen Case that would allow the debtor to select the beneficiary for its duties — e.g., shareholders, creditors, etc.741 Although that approach would provide certainty to the process, the Commissioners expressed concerns about strategic maneuvers, collusion, and conflicts with state entity governance law. As such, the Commissioners found that the most efficient approach would be to impose whatever duties applicable state entity governance law would impose in these circumstances. This approach also would be consistent with other duty-related principles discussed by the Commission. In addition, the Commission agreed that professionals for the debtor in possession should not be disqualified from representing the debtor in the plan process solely on the basis that such professionals were representing the debtor in two different capacities. The Commissioners acknowledged that requiring separate professionals would impose unnecessary and likely duplicative costs on the estate with no real advantages, provided that the professionals otherwise were disinterested and satisfied section 327 or 328 of the Bankruptcy Code. 740 See, e.g., Written Statement of Thomas J. Salerno: CFRP Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 5 (Nov. 7, 2013) (“[C]ertain provisions of the Bankruptcy Code related to the plan negotiation process appear inconsistent with imposition of a duty of loyalty to creditors of the estate occurring in plan negotiations. In light of these provisions, and the sheer impossibility of absolute loyalty to two adverse interests in the negotiating process, it appears that directors and officers are not held, and should not be held, to the same fiduciary duty of loyalty to the estate in the negotiation of a plan.”), available at Commission website, supra note 55. 741 See Stephen H. Case, Fiduciary Duty of Corporate Directors and Officers, Resolution of Conflicts Between Creditors and Shareholders, and Removal of Directors by Dissident Shareholders in Chapter 11 Cases 13, in C371 A.L.I.-A.B.A. 1, 17 (Study Materials for A.L.I.-A.B.A.’s Williamsburg Conference on Bankruptcy, Oct. 17–19, 1988) (explaining that the duty of impartiality imposed on directors of a debtor in possession should permit those directors to elect to act in a pro-creditor, pro-equity, or stakeholder mediator capacity).  VI. Proposed Recommendations: Exiting the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 207 of 402 ABI Commission to Study the Reform of Chapter  B. Approval of Section 363x Sales Recommended Principles: The court should approve a sale of all or substantially all of a debtor’s assets only if the court finds by a preponderance of the evidence that the proposed sale is in the best interests of the estate and satisfies the following requirements: o The sale complies with the applicable provisions of the Bankruptcy Code. (Comparable plan provision found at 11 U.S.C. § 1129(a)(1).) o The proponent of the sale complies with the applicable provisions of the Bankruptcy Code. (Comparable plan provision found at 11 U.S.C. § 1129(a)(2).) o The sale has been proposed in good faith and not by any means forbidden by law. (Comparable plan provision found at 11 U.S.C. § 1129(a)(3).) o Any payment made or to be made by the debtor or by a person acquiring property in the sale for services or for costs and expenses in or in connection with the case, or in connection with the sale and incident to the case, has been approved by, or is subject to the approval of, the court as reasonable. (Comparable plan provision found at 11 U.S.C. § 1129(a)(4).) o Except to the extent that the holder of a particular claim 6 agreed to has 01 a different treatment of such claim, the trustee proposes 2 use or reserve r 21, to be vem sufficient proceeds from the sale to satisfyon Nfull allowed claims of a kind in o d hive specified in section 507(a)(2) 536(3) rincurred through the date of the closing or 3 a c -3 o 14 of the sale. (Comparable .plan provision found at 11 U.S.C. § 1129(a)(9)(A).) n, N Brow th v. o All feesxspayable under section 1930 of title 28 of the U.S. Code, as li e nB ted i cidetermined by the court at the hearing on the sale, have been paid or the trustee provides for the payment of all such fees on the date of the closing of the sale. (Comparable plan provision found at 11 U.S.C. § 1129(a)(12).) o The trustee has provided adequate notice and an opportunity to be heard to all creditors and equity security holders who may be affected by a release or discharge that provides claims protection for the purchaser in the order approving the sale. A section 363x sale is subject to the principles on orders resolving chapter 11 cases. See Section VI.G, Orders Resolving Chapter 11 Case (Exit Orders). These principles refer to “a sale of all or substantially all of a debtor’s assets” as a “section  363x sale.” For the timing of section 363x sales, see Section IV.C.2, Timing of Section 363x Sales. The other recommended principles relating to transactions outside the ordinary course also apply in the section 363x sale context. See Section V.B, Use, Sale, or Lease of Property of the Estate. VI. Proposed Recommendations: Exiting the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 208 of 402 Bankruptcy Institute Approval of Section 363x Sales: Background As explained above, a debtor in possession742 may seek to sell all or substantially all of its assets under section 363(b) of the Bankruptcy Code.743 This kind of sale (referred to in these principles as a “section 363x sale”) is a value realization event in the chapter 11 case, as it involves monetizing nearly all of the assets available to satisfy claims against and interests in the estate. Because a section 363x sale terminates the estate’s and, in turn, creditors’ interests in the assets, the process to facilitate such a sale is critically important to the recoveries ultimately received by creditors. The timing of a section 363 sale can significantly impact value and raises notice and due process concerns; timing issues are addressed separately above.744 A section 363x sale transforms the estate from illiquid assets with fluctuating value to a fixed sum of money or securities.745 Consequently, it potentially alters the value of the estate in a positive or negative direction, depending on factors such as the timing of the sale, the marketing of the assets, the competitive nature of the auction, and the sale and restructuring alternatives explored by the debtor in possession leading up to the section 363x sale. Anecdotal evidence suggests that section 363x sales can facilitate quicker sales that create value for the estate.746 Such evidence also suggests, however, that a bidder may pursue certain strategies such as a “loan-to-own” strategy or streamlined sale process that may chill bidding and depress the value of the assets.747 742 743 744 745 16 1, 20 ber 2applicable under section 1107 As previously noted, references to the trustee are intended to include the debtor in possession as ovem of the Bankruptcy Code, and implications for debtors in possession also apply ton N chapter 11 trustee appointed in the case. ed o any See supra note 76 and accompanying text. See generally Section IV.A.1, rchiv The Debtor in Possession Model. 63 a See Section V.B, Use, Sale, or Lease of Property of the Estate.4See5also George W. Kuney, Let’s Make It Official: Adding an Explicit -3 3 .1 Preplan Sale Process as an Alternative Exit from Bankruptcy, 40 Hous. L. Rev. 1265, 1267–68 (2004) (discussing increasing use of , No rown chapter 11 to sell assets). B h v. See Section IV.C.2, Timing of Section 363x Sales. ixset n BlLeary: SABA/NAAG Annual Seminar Field Hearing Before the ABI Comm’n to Study the Reform i See Written Statement ofiMaureen c ted of Chapter 11 (Oct. 8, 2013) (describing the potential negative consequences to creditors and, in turn, problems with sales of substantially all of a debtor’s assets under section 363), available at Commission website, supra note 55. 746 For a thorough discussion of the competing perspectives on section 363 sales of all or substantially all of a debtor’s assets in chapter 11, see In re Gulf Coast Oil Corp., 404 B.R. 407, 419 (Bankr. S.D. Tex. 2009) (reviewing the relevant case law, treatises, and academic literature). See also Stuart Gilson, Coming Through in a Crisis: How Chapter 11 and the Debt Restructuring Industry Are Helping to Revive the U.S. Economy, 24 J. Applied Corp. Fin. 23 (2012) (“Increasingly, distressed companies have also taken advantage of Chapter 11 as a more efficient way to sell assets.”); Jared A. Wilkerson, Defending the Current State of Section 363 Sales, 86 Am. Bankr. L. J. 591 (2012) (refuting criticism of section 363 sales in chapter 11 and highlighting potential efficiencies of such sales). See generally Section IV.C.2, Timing of Section 363x Sales. 747 See, e.g., Michelle M. Harner, Trends in Distressed Debt Investing: An Empirical Study of Investors Objectives, 16 Am. Bankr. L. Rev. 69 (2008) (reporting results of empirical survey on, among other issues, investors’ loan-to-own strategies in bankruptcy). See generally supra note 66 and accompanying text (generally discussing limitations of chapter 11 empirical studies). See also Jonathan M. Landers, Reflections on Loan-to-Own Trends, Am. Bankr. Inst. J., Oct. 2007, at 44–46 (explaining loan-to-own transactions); Kenneth M. Ayotte & Edward R. Morrison, Creditor Control and Conflict in Chapter 11, 1 J. Legal Analysis 511, 513 (2009) (discussing, among other things, impact of creditor control on the decision to sell assets in bankruptcy); Tabb, The Bankruptcy Clause, the Fifth Amendment, and the Limited Rights of Secured Creditors in Bankruptcy, supra note 115 (“Controlling secured lenders often use chapter 11 as a vehicle to foreclose on their assets. Traditional corporate reorganizations are becoming a rara avis; the strongly emerging norm is for debtors to be liquidated in speedy ‘§ 363 sales,’ the reference being to the Bankruptcy Code section authorizing sales. This practice has become so prevalent that a coauthor and I have spoken of the ‘new ‘Chapter 3’ reorganization.’”); Brubaker, Credit Bidding and the Secured Creditor’s Baseline Distributional Entitlement in Chapter 11, supra note 542, at 10 (“The ‘loan to own’ phenomenon has caused some to question the advisability of credit bidding. The basic concern seems to be that a ‘loan to own’ lender’s primary incentive is, unlike a traditional lender, acquiring the debtor’s assets as cheaply as possible, rather than maximizing the recovery on its secured loan. A traditional lender has every incentive to maximize the sale price of its collateral through vigorous competitive bidding, sincerely hoping that bid prices will exceed the amount it could credit bid with its existing secured loan, as this would mean a full recovery on that loan. A ‘loan to own’ lender, though, has every incentive to inhibit competitive bidding in order to ensure that bid prices will not exceed the amount it can credit bid with its existing secured loan, as this would mean that the ‘loan to own’ lender can acquire the debtor’s assets solely through a credit bid of its existing secured loan and with no additional investment.”); Jay Lawrence Westbrook, The Control of Wealth in Bankruptcy, 82 Tex. L. Rev. 795, 846 (2004) (“In both judicial and private auction sales, there are often strict requirements for a bidder other than the secured party. In particular, the bidder may have to bring sufficient cash to cover its bid or to provide cash payment very shortly after the bidding. For this and other reasons, it is often the case that few other bidders appear at foreclosure and repossession sales. This fact combines with the bidding-in rules to make it possible for secured parties to buy at their own sales at a price well below market value while avoiding sanctions for violating Article 9’s notice and sale procedures.”).  VI. Proposed Recommendations: Exiting the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 209 of 402 ABI Commission to Study the Reform of Chapter  The limited empirical data on section 363x sales are mixed in results and difficult to interpret because the coding of the debtor’s exit strategy as a liquidation, going concern sale (i.e., section 363x sale), or confirmed plan often is very subjective, and the data are “noisy” in this respect.748 It also is challenging for empiricists to collect and code creditors’ recoveries, particularly in cases that do not have publicly traded securities. In fact, much of the data on chapter 11 cases speak only to the large chapter 11 cases.749 For example, the chart shown below demonstrates a positive linear trend (illustrated by the dotted line) in the number of section 363 sales in chapter 11 cases, but it also is limited to large public companies.750 in cited 16 1, 20 ber 2 vem n No ed o rchiv 63 a -353 . 14 , No rown .B eth v Blixs Year 748 See, e.g., Lynn M. LoPucki & Joseph W. Doherty, Bankruptcy Fire Sales, 106 Mich. L. Rev. 1 (2007) (study analyzing large public company bankruptcy cases and finding that recoveries in reorganization cases are more than double recoveries from going concern sales); James J. White, Bankruptcy Noir, 106 Mich. L. Rev. 691 (2007) (critiquing the LoPucki & Doherty study and finding no statistical difference between sale prices and reorganization prices); Lynn M. LoPucki & Joseph W. Doherty, Bankruptcy Verite, 106 Mich. L. Rev. 721 (2008) (responding to the White study). See also, e.g., Jenkins & Smith, Creditor Conflict and the Efficiency of Corporate Reorganization, supra note 42 (developing model to assess efficient and inefficient liquidations in bankruptcy and concluding that about 8 percent of firms are inefficiently liquidated — i.e., they were liquidated when it would have been more efficient to reorganize); Edith S. Hotchkiss & Robert M. Mooradian, Acquisitions as a Means of Restructuring Firms in Chapter 11, 7 J. Fin. Intermediation, 240–262 (1998) (providing “empirical evidence that takeovers can facilitate the efficient redeployment of assets of bankruptcy firms”). See generally supra note 66 and accompanying text (generally discussing limitations of chapter 11 empirical studies). 749 For example, many chapter 11 empirical studies use the UCLA-LoPucki Bankruptcy Research Database or a similarly restricted database. The UCLA-LoPucki Bankruptcy Research Database includes all bankruptcy cases filed between 1980 and 2012 by or against a business debtor or group of affiliated debtors that had assets worth $100 million or more, measured in 1980 dollars. 750 Mr. Shrestha prepared this chart for the Commission based on data from the UCLA-LoPucki Bankruptcy Research Database. Accordingly, it was limited to large public companies. The chart analyzes all Section 363 Sales in the UCLA-LoPucki Bankruptcy Research Database (including confirmed, pending, converted, and dismissed cases). Because certain of the cases included in this analysis did not include data for the date of the sale order, some of these data are not included in the chart describing the median duration between the petition date and sale order date in bankruptcy cases. See Section IV.C.2, Timing of Section 363x Sales. But see Jay Lawrence Westbrook, The Role of Secured Credit in Chapter 11 Cases: An Empirical Review, 2015 Ill. L. Rev.__, at *6 (forthcoming 2015) (finding, in an empirical study of 424 cases covering a broad cross section of chapter 11 debtors in nine districts, that only about 25 percent of cases and any sales out of the ordinary course, suggesting that section 363 sales are less common that previously thought) (draft on file with Commission). See generally supra note 66 and accompanying text (generally discussing limitations of chapter 11 empirical studies). VI. Proposed Recommendations: Exiting the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 210 of 402 Bankruptcy Institute Moreover, chapter 11 cases — unlike consumer bankruptcy cases — often present unique facts and involve dynamics not reflected on the court docket. Accordingly, although the data are extremely informative, they should be read with caution, and any claims of causality should be critically analyzed given the foregoing factors and related research limitations (e.g., endogeneity bias, sample selection bias) that may impact research issues in this area.751 As suggested above, a section 363x basically determines the maximum recovery any particular creditor will receive in the case. In a case where the debtor’s assets are sold for less than the value of the secured claims asserted against the estate, junior creditors — including those holding prepetition unsecured claims and, potentially, postpetition administrative claims relating to the administration of the case following the sale — may not receive any distributions. Although a debtor that liquidates in chapter 11 does not receive a discharge, for all practical purposes, a section 363x essentially discharges the primary source of recovery in business cases (i.e., the debtor’s assets). Accordingly, many courts raise concerns regarding section 363x sales in chapter 11 cases. Among other things, courts and commentators note that these sales skirt the notice and due process protections of the plan process, are often pursued before parties in interest have adequate information to assess the sale and a debtor’s restructuring alternatives, and may determine ultimate distributions to creditors without creditors having a vote or the protections of the “fair and equitable” standard of section 1129(b).752 Nevertheless, as many of these courts recognize, a debtor in possession may 6 have no viable restructuring alternatives, and the section 363x sale mayein 1, 201 fact represent its best b r2 opportunity for providing recoveries to at least some stakeholders.ovem N In these circumstances, many d on chive ar courts strive to make a going concern sale work under3the current Bankruptcy Code, but it was not 3536 753 . 14an intended, and thus is not a perfect, fit. n, No d h v. xset n Bli i Brow cite Approval of Section 363x Sales: Recommendations and Findings Some commentators argue that a sale of all or substantially all of a debtor’s assets is akin to a traditional reorganization in that it is a change-of-control event that facilitates distributions of value to creditors and frequently continues the business of the debtor in some form. The Commissioners debated this general proposition at length. Although the Commissioners held differing views on what qualifies as “reorganization” under chapter 11, many of the Commissioners believed that sales of all or substantially all of a debtor’s assets have become part of the restructuring landscape. As such, the Commission agreed that the most constructive approach to the issue was to analyze critically the sale process, recognizing the potential utility of the process in achieving certain policy goals, including maximizing value for creditors and preserving jobs for at least part of the debtor’s workforce. 751 See generally supra note 66 and accompanying text (generally discussing limitations of chapter 11 empirical studies). 752 See, e.g., In re Gen. Motors Corp., 407 B.R. 463, 491 (Bankr. S.D.N.Y. 2009), aff ’d, In re Motors Liquidation Co., 430 B.R. 65 (S.D.N.Y. 2010) (“[A] debtor cannot enter into a transaction that ‘would amount to a sub rosa plan of reorganization’ or an attempt to circumvent the chapter 11 requirements for confirmation of a plan of reorganization.”). But see Comm. of Equity Sec. Holders v. Lionel Corp.(In re Lionel Corp.), 722 F.2d 1063, 1071 (2d Cir. 1983) (“Every sale under § 363(b) does not automatically short-circuit or side-step Chapter 11; nor are these two statutory provisions to be read as mutually exclusive. Instead, if a bankruptcy judge is to administer a business reorganization successfully under the Code, then . . . some play for the operation of both § 363(b) and Chapter 11 must be allowed for.”). 753 See, e.g., In re Chrysler LLC, 405 B.R. 84, 96 (Bankr. S.D.N.Y. 2009), appeal dismissed, 592 F.3d 370 (2d Cir. 2010) (“A debtor may sell substantially all of its assets as a going concern and later submit a plan of liquidation providing for the distribution of the proceeds of the sale. This strategy is employed, for example, when there is a need to preserve the going concern value because revenues are not sufficient to support the continued operation of the business and there are no viable sources for financing.”).  VI. Proposed Recommendations: Exiting the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 211 of 402 ABI Commission to Study the Reform of Chapter  As discussed above, a key concern among the Commissioners was the timing of section 363x sales, which they believed should be conducted in a methodical manner and on a reasonable timeline so that the debtor can identify, and creditors can confirm, that the sale not only provides the best and highest offer for the assets, but also the best restructuring alternative for the debtor and all of its stakeholders. The Commission recommended a 60-day moratorium on section 363x sales to promote these objectives.754 The Commissioners reflected on the meaningful differences between a section 363x sale process and the chapter 11 plan process. They considered both substantive and procedural aspects of the process. For example, courts use slightly different standards of review in approving sales of substantially all of a debtor’s assets under section 363 of the Bankruptcy Code.755 Most courts employ some form of heightened scrutiny, but that review may simply turn on whether the debtor in possession has a “good reason” for the proposed sale under the circumstances of the particular case.756 Such a standard is a much different and arguably lower standard than that applied to confirmation of a chapter 11 plan in the cramdown context.757 The Commissioners observed that a cramdown analysis generally is applicable because most classes of creditors will be impaired by the sale and receive nominal, if any, distributions from the sale proceeds. Moreover, creditors do not get a “vote” on the sale. To confirm a plan under the section 1129 cramdown standard, a debtor must establish that the plan (i) satisfies 754 See Section IV.C.2, Timing of Section 363x Sales. 755 See Comm. of Equity Sec. Holders v. Lionel Corp. (In re Lionel Corp.), 722 F.2d 1063, 1072 (2d Cir. 1983) (reviewing historical 16 standard applicable to bankruptcy sales and finding more flexibility under section 363(b), 20 1, noting that “[i]n fashioning its ber 2 interest groups; rather, he should findings, a bankruptcy judge must not blindly follow the hue and cry of the mostvem special vocal n No consider all salient factors pertaining to the proceeding and, accordingly, act to further the diverse interests of the debtor, ed o Inc., 2008 WL 2951974, at *6 (Bankr. D. Del. July v creditors and equity holders, alike”). See also In re Whitehall JewelersiHoldings, arch 28, 2008) (“[W]hen a preconfirmation [section] 363(b)-353is3 all, or substantially all, of the Debtor’s property, and is proposed sale 6 of 4 during the beginning stages of the case, the saleNo. 1 , transaction should be ‘closely scrutinized, and the proponent bears a heightened rown burden of proving the elements necessary for authorization’”) (citation omitted); In re George Walsh Chevrolet, Inc., 118 B.R. 99, v. B 101 (Bankr. E.D. Mo. 1990)ixsesale of substantially all of the Debtor’s assets other than in the ordinary course of business and (“A th naBl i without the structure of Chapter 11 Disclosure Statement and Plan . . . must be closely scrutinized and the proponent bears a cited heightened burden of proving the elements necessary for authorization.”); In re Indus. Valley Refrigeration & Air Conditioning Supplies, Inc., 77 B.R. 15, 17 (Bankr. E.D. Pa. 1987) (holding that a sale of virtually all of the debtor’s assets “can be permitted only when a good business reason for conducting a preconfirmation sale is established and . . . the burden of proving the elements for approval of any sale out of the ordinary course of business — including provision of proper notice, adequacy of price, and ‘good faith’ — is heightened”). 756 See Comm. of Equity Sec. Holders v. Lionel Corp. (In re Lionel Corp.), 722 F.2d 1063, 1071 (2d Cir. 1983) (“The rule we adopt requires that a judge determining a § 363(b) application expressly find from the evidence presented before him at the hearing a good business reason to grant such an application.”). See also In re Boston Generating, LLC, 440 B.R. 302, 321 (Bankr. S.D.N.Y. 2010) (“[A] court rendering a section 363(b) determination must ‘expressly find from the evidence presented . . . a good business reason to grant such application.’”) (citations omitted); In re Daufuskie Island Props., LLC, 431 B.R. 626, 637 (Bankr. D.S.C. 2010) (“(Because the sale is one of substantially all assets of the Estate prior to confirmation of a Chapter 11 plan in this case, authorization for the sale under § 363(b)(1) requires that the Trustee satisfy the ‘sound business purpose’ test for preconfirmation sales.”); In re Gen. Motors Corp., 407 B.R. 463, 489 (Bankr. S.D.N.Y. 2009), aff ’d, In re Motors Liquidation Co., 430 B.R. 65 (S.D.N.Y. 2010) (“[I]t is plain that in the Second Circuit, as elsewhere, even the entirety of a debtor’s business may be sold without waiting for confirmation when there is a good business reason for doing so.”); In re Nicole Energy Servs., Inc., 385 B.R. 201, 10 (Bankr. S.D. Ohio 2008) (“[T]he Court may approve a sale of all of a debtor’s assets under § 363(b) ‘when a sound business purpose dictates such action.’”). 757 First Report of the Commercial Fin. Ass’n to the ABI Comm’n to Study the Reform of Chapter 11: Field Hearing at Commercial Fin. Ass’n Annual Meeting, at 16–17 (Nov. 15, 2012) (“Chapter 11 plans of liquidation continue to grow in popularity as a ‘reorganization’ option but offer less protection to creditors, including secured creditors, than a liquidation under Chapter 7. In almost all cases, once the Chapter 11 plan of liquidation has been confirmed, it is the debtor or liquidating trustee who conducts the liquidation without further input from creditors and often with limited (if any) judicial oversight. As a result, creditors have little or no input into the liquidation decisions made by the liquidating trustee/debtor beyond the information contained in the disclosure statement, and there is no real ability on the part of creditors to oversee the liquidation that is being accomplished — allegedly for their benefit. . . . It is becoming commonplace that courts will not condone a §363 sale which disposes of substantially all of the estate’s assets without the court and the creditors being advised as to the terms of ‘wind-down’ or a plan of liquidation. Similarly, many courts allow for what are referred to as “structured dismissals” in lieu of either a Chapter 11 plan of liquidation or a conversion to Chapter 7, without any specific statutory underpinning. Without giving any real guidance as to when a Chapter 11 liquidation is appropriate and the level of interaction available to creditors if the Debtor has not complied with the plan or refuses to cooperate, the secured lender is left only with the option of reclaiming its collateral.”), available at Commission website, supra note 55; See Written Statement of Maureen Leary: SABA/NAAG Annual Seminar Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (Oct. 8, 2013) (suggesting higher standard of review for sales under section 363(b) and (f)), available at Commission website, supra note 55. VI. Proposed Recommendations: Exiting the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 212 of 402 Bankruptcy Institute all of the requirements of section 1129(a) (including good faith, the best interests of creditors test, and payment of all administrative claims and certain priority claims), except section 1129(a)(8); and (ii) does not discriminate unfairly and is fair and equitable with respect to each dissenting impaired class under section 1129(b).758 In general, a plan discriminates unfairly against an impaired dissenting class if it provides greater value to a class of claims or interests with equal priority. “In a nutshell, if the plan protects the legal rights of a dissenting class in a manner consistent with the treatment of other classes whose legal rights are intertwined with those of the dissenting class, then the plan does not discriminate unfairly with respect to the dissenting class.”759 Section 1129(b)(2) sets forth certain standards that must be met for the plan to be considered fair and equitable as to dissenting impaired classes of secured and unsecured claims and equity interests. The legislative history, however, also makes clear that certain factors that are relevant to the fair and equitable determination are not specified in section 1129.760 The most common factor considered in this context is a prohibition on a senior class receiving more than 100 percent of its claim in a cramdown scenario. In addition to substantive distinctions, the Commissioners observed that, particularly in an expedited sale process, many creditors do not receive notice of the sale or sufficient information to evaluate the sale. Yet the sale may eviscerate any recoveries for unsecured creditors in the case, and could subject some or all of the creditors to third-party releases or discharges that impact the parties 16 and property potentially available to satisfy their claims. The Commissioners2believed that more 1, 0 ber 2 ov meaningful notice to a broader audience is necessary and appropriate em many cases. on N in ived arch 363 5 Overall, the Commissioners found little , No. 14-3 in the consequences to creditors’ rights and difference n w claims under an order approving v. Bro th a section 363x sale or an order confirming a chapter  11 plan. lixse in B They did find, however,dsignificant differences in the creditor protections available under the two cite processes. Considering the potentially greater exposure to loss of value in the sale context where the assets are being removed from the estate, the Commission ultimately determined that creditors should be afforded at least the same level of protection in the section 363x sale process and in the chapter 11 plan process. The proposed procedural principles for section 363x incorporate these recommendations. 758 11 U.S.C. § 1129(a), (b). 759 Kenneth N. Klee, All You Ever Wanted to Know About Cram Down Under the New Bankruptcy Code, 53 Am. Bankr. L. J. 133, 142 (1979). 760 Id.  VI. Proposed Recommendations: Exiting the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 213 of 402 ABI Commission to Study the Reform of Chapter  C. Value Determinations, Allocation, and Distributions 1. Creditors’ Rights to Reorganization Value and Redemption Option Value Recommended Principles: A class of senior creditors should be entitled to receive in respect of their secured claims distributions under the chapter 11 plan or order approving a section 363x sale having a value equal to the reorganization value (or portion thereof) attributable to the collateral securing their claims as of the effective date of the plan or the date of a section 363x sale order, unless such classes agree to accept different treatment. For purposes of this principle, the term “reorganization value” means (i) if the debtor is reorganizing under the plan, the enterprise value attributable to the reorganized business entity, plus the net realizable value of its assets that are not included in determining the enterprise value and are subject to subsequent disposition as provided in the confirmed plan; or (ii) 16 the debtor is 0 if 21, 2 ber or a chapter 11 plan, selling all or substantially all of its assets under section 363x vem n No ed o the net sale price for the enterprise plus archiv realizable value of its assets that the net 3 -3 subject to subsequent disposition as provided are not included in such sale and1are 536 . 4 , No in the confirmed plan Brown contemplated at the time of the section 363x sale.761 or as v. eth Blixs ed in date set cit valuation The by the effective date of a plan or the date of a section 363x sale order should not foreclose, in appropriate cases, a distribution in the chapter 11 case on account of the possibility of future appreciation in the firm’s value due to the firm’s continuation as a going concern. Although the valuation at any point in time will necessarily reflect the debtor’s future potential, the valuation may occur during a trough in the debtor’s business cycle or the economy as a whole, and relying on a valuation at such a time may result in a reallocation of the reorganized firm’s future value in favor of senior stakeholders and away from junior stakeholders in a manner that is subjectively unfair and inconsistent with the Bankruptcy Code’s principle of providing a breathing spell from business adversity. Accordingly, except in small and medium-sized enterprise cases, the general priority scheme of chapter 11 should incorporate a mechanism to determine whether distributions to stakeholders should be adjusted due to the possibility of material changes in the value of the firm within a reasonable period of time after the plan effective date or section 363x sale order date, as the case may be. This adjustment should consider whether the class immediately junior to a senior 761 In the case of a sale, the reorganization value is limited to the net value actually available for distributions to creditors after any applicable reductions, expenses, or charges. VI. Proposed Recommendations: Exiting the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 214 of 402 Bankruptcy Institute class762 benefiting from preserving the firm’s value as a going concern in connection with a chapter 11 plan or section 363x sale (the “immediately junior class”) should receive an allocation of value to recognize that the future possibilities of the ongoing firm include the possibility that such an immediately junior class might have been in the money or received a greater recovery if the firm had been valued at a later date.763 In furtherance of this principle, except in small and medium-sized enterprise cases, an immediately junior class that might otherwise be permanently cut off from receiving value based on the reorganization value as of the effective date of the plan or the date of the section  363x sale order should be entitled to an allocation of value referred to as the “redemption option value” attributable to such class, as defined below. A distribution of redemption option value, if any, would be made to an immediately junior class to reflect the possibility that, between the plan effective date or sale order date and the third anniversary of the petition date (the “redemption period”), the value of the firm might have been sufficient to pay the senior class in full with interest and provide incremental value to such immediately junior class.764 As explained below, the redemption option value in any given case may be negligible or non existent; it is not a percentage or fixed payment to junior creditors. 016 ,2 er 21 emb In accordance with the above general principles, on Nov 1129(b) should be section d chive amended to provide that, subject to the conditions described below, 3 ar 3536 . 14, No (a) a chapter 11 plan may be confirmed over the non-acceptance of the immediately own v. Br junior class if Blixseonly if such immediately junior class receives not less than and th ed in option value, if any, attributable to such class, and cit the redemption (b) a chapter 11 plan may be confirmed over the non-acceptance of a senior class of creditors, even if the senior class is not paid in full within the meaning of the absolute priority rule, if the plan’s deviation from the absolute priority rule 762 For purposes of applying these principles in connection with a chapter 11 plan when there is no sale of the firm, the relevant senior stakeholders are the class or classes of senior creditors receiving the residual interests (e.g., equity securities) in the firm that will benefit from the firm’s appreciation after the effective date of the plan. Generally speaking, outside the sale context (whether the sale is under section 363x or pursuant to a plan), a senior class paid in cash or solely in debt securities of the reorganized firm that receives no ongoing interest in the residual value (e.g., equity) of the firm would not be required to share reorganization option value, which is intended to represent an allocation of value arising from the possibility of future appreciation in the value of the reorganized firm, with a junior class. How the principles would be applied when the residual interests in the firm are allocated among several senior classes is an issue that requires further development. In the context of a sale of substantially all of the assets of the firm, whether under section 363x or pursuant to a plan, the distribution to the immediately junior class would, generally speaking, be from the senior class’s or classes’ otherwise-applicable entitlement to the proceeds of the sale and would be made in cash or such other consideration that allocates the redemption option value to such immediately junior class from such proceeds. 763 In theory, this principle should apply to the allocation of the estate’s value between senior and junior classes of creditors, whether the relative priority of their claims arises from liens, contractual subordination, or otherwise. 764 Because redemption option value is determined based on the presumption that the senior class, including any unsecured deficiency claims of the senior class if the senior class holds secured claims, is paid in full, under this principle the deficiency claims held by the senior class generally would not be entitled to share in redemption option value even if such a deficiency claim would be otherwise included in the immediately junior class.  VI. Proposed Recommendations: Exiting the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 215 of 402 ABI Commission to Study the Reform of Chapter  treatment of the senior class is solely for the distribution to an immediately junior class of the redemption option value, if any, attributable to such class. Notwithstanding clause (a) above, however, if a chapter 11 plan is rejected by the immediately junior class and such class challenges the reorganization value used to determine such class’s entitlement to redemption option value under such plan, the plan should be confirmed over the non-acceptance of such immediately junior class if (i) the court finds, based on the evidence presented at the confirmation hearing, that such reorganization value was not proposed in bad faith, and (ii) the plan satisfies, with respect to such immediately junior class, the requirements of section 1129(b) other than the requirement that reorganization option value be provided to such class. Similarly, except in small and medium-sized enterprise cases, section 363 should be amended to provide that, in the context of a section 363x sale, if the members of an immediately junior class do not object to the sale, the immediately junior class should be entitled to receive from the reorganization value attributable to such sale not less than the redemption option value, if any, attributable to such immediately junior class.765 If, however, the immediately junior class objects to the sale, they will not be entitled to such redemption option value. 6 , 201 er 21 bclass would otherwise Based on these principles, even if an impaired senior vem n No ed o be entitled to the entirety of the reorganization value of the firm based on its hiv 3 arc reorganization value on the effective 36 of the plan or date of the section 363x -35 date 14 No. sale order, the courtv.should, not confirm the plan over the non-acceptance of the rown B th immediatelyBlixse class or approve a sale under section 363x that is not objected n junior i cited to by members of the immediately junior class, as the case may be, unless the plan or the order approving the section 363x sale, as applicable, provides for an allocation of redemption option value to the immediately junior class to the extent of its entitlement thereto as described above. o The “redemption option value” attributable to such immediately junior class is the value of a hypothetical option to purchase the entire firm with an exercise price equal to the redemption price (as defined below) and a duration equal to the redemption period (as defined above).766 o Generally speaking, the immediately junior class will be the class of stakeholders that would first derive material benefit from future increases in the reorganization value of the firm after payment in full of all senior classes receiving distributions under the plan. The immediately junior class 765 The Commission recognized that an individual creditor, several creditors, or the entire class could file objections to the sale. The Commission did not resolve the level of objection required, or whether an objection that was overruled by the court would preclude only that creditor’s entitlement to any redemption option value. 766 Since this principle establishes a minimum recovery for the junior class where the class members have not objected to the section 363x sale, the reorganization value is fixed at the net value realized by the estate in connection with the sale. As noted below, the junior class can still dispute how the redemption option value is being calculated for such reorganization value (by presenting evidence on other components of the redemption option value calculation, such as volatility). On the other hand, if there is no section 363x sale, the junior class may contest the reorganization value under the plan, and trigger application of the absolute priority rule by rejecting the plan and in that context the junior class could assert the right to a portion of a higher reorganization value. VI. Proposed Recommendations: Exiting the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 216 of 402 Bankruptcy Institute will typically be the class immediately junior to the fulcrum security class (i.e., the most junior class in the debtor’s capital structure receiving material distributions in the case and at which the firm’s reorganization value is exhausted at the time of the enterprise valuation in the case). However, if under the plan the fulcrum class will receive a relatively small participation in the residual value of the firm at the current reorganization value because the bulk of such participation is allocated to other more senior classes, the fulcrum class may be the immediately junior class for these purposes. o Where the senior class would otherwise be entitled to the entire value of the firm, the “redemption price” of the hypothetical option would be the full face amount of the claims of the senior class,767 including any unsecured deficiency claim, plus any interest at the non-default contract rate768 plus allowable fees and expenses unpaid by the debtor, in each case accruing through the hypothetical date of exercise of the redemption option, as though the claims remained outstanding on the date of the exercise of the option. o A redemption period would be specified for purposes of setting the duration of the redemption option commencing on the effective date of the plan or the date of the section 363x sale order and ending on the third anniversary of the petition date. 6 , 201 The court would determine the redemption option value, emany,21 if ber attributable to Nov on the immediately junior class based on the evidenceepresented by the parties at the iv d arch hearing under section 1129(b) or section363 5 363x, as the case may be. The parties 14-3 No. may, for example, demonstraten,the existence, or lack, of any redemption option Brow th v. value through generally accepted market-based valuation models, including the lixse in B cited Black-Scholes option pricing model, using reasonable assumptions based on the facts of the particular case. The redemption option value could be paid pursuant to the plan or section 363x sale order in the form of cash, debt, stock, warrants, or other consideration, provided that any non-cash consideration would be valued on a basis consistent with the manner in which reorganization value was determined. The form of consideration used to provide redemption option value to the immediately junior class should be subject to the election of the senior class being required to give up such value, regardless of whether such senior class has accepted the plan. The value distributed to the immediately junior class under these principles need not be, and in most cases likely would not be, in the form of an actual option. 767 In more complex cases, where a single senior class is not entitled to the entire reorganization value of the firm and other classes senior to the immediately junior class are receiving distributions, the redemption price would have to be adjusted to include the claims of all of such senior classes, whether or not they are receiving residual interests in the firm or are among the classes required to share reorganization option value with the immediately junior class. 768 The Commission discussed the appropriate interest rate to be used in determining the redemption option value and decided to use the non-default contract rate. Some Commissioners expressed the view that the default contract rate or a rate reflecting the risk of investing in the equity of the reorganized debtor should be used because the senior creditor is absorbing all of the downside risk inherent in such equity while sharing the upside potential.  VI. Proposed Recommendations: Exiting the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 217 of 402 ABI Commission to Study the Reform of Chapter  The requirement is that the requisite value of such an option be distributed to the immediately junior class, regardless of form. If an immediately junior class is not entitled to redemption option value for any of the reasons set forth above, such immediately junior class would be entitled to receive distributions only on a strict absolute priority basis under section 1129(b) as of the effective date of the plan, as under current law, and no special provision for redemption option value would have to be made for such class in accordance with the above principles. A senior creditor’s election under section 1111(b) of the Bankruptcy Code should not dilute or otherwise affect the immediately junior class’s rights to receive any redemption option value under the distribution rules set forth in this principle. The principles set forth above are not intended to alter the order of creditor priorities or to affect allocations within a particular class of creditors; rather, the principles speak generally to how courts should determine whether the reorganization value of the debtor or its assets is sufficient to support a distribution to the immediately junior class. The principles set forth above attempt to provide a conceptual framework for an 6 , 201 adjustment to the current absolute priority rule, which often1results in wasteful ber 2 em nN and time-consuming litigation over reorganizationovvalue in recognition that ed o hiv the determination of reorganization5valuerc the effect of cutting off alternative 63 a has -3 3 . 4 distributional possibilities based 1 the fortuity of timing of the reorganization or , No on rown B h . sale. It is importantvto note, however, that the conceptual principle of allocating xset n Bli i cited redemption option value to the immediately junior class requires further development to determine whether and how it should be applied in more complex contexts, for example where a senior class is entitled to less than all of the firm’s enterprise value (for example where it is secured by only some of the assets of the firm), where contractual or structural subordination (rather than a lien) results in an immediately junior class, where there are multiple classes senior to the immediately junior class and not all such senior classes are receiving distributions in the form of interests in the residual value of the firm, where only part of the immediately junior class objects to a sale or challenges reorganization value under a plan, or where some enterprise value is distributable at the current enterprise valuation to an immediately junior class, but the junior class is not being paid in full. Creditors’ Rights to Reorganization Value and Redemption Option Value: Background The Bankruptcy Code operates, among other things, to evaluate creditors’ rights based, in part, on their state law entitlements and priorities. Commentators and practitioners frequently debate exactly what state law entitlements and priorities mean in the context of secured creditors. Exactly which secured creditors’ rights can be modified? Are any of those rights inviolate? A variety of factors affect VI. Proposed Recommendations: Exiting the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 218 of 402 Bankruptcy Institute this analysis, including the secured creditors’ rights under state law and the Fifth Amendment of the U.S. Constitution, and Congress’s ability to “establish . . . uniform Laws on the subject of Bankruptcies throughout the United States” under the Bankruptcy Clause of the U.S. Constitution.769 The Fifth Amendment provides in relevant part: “No person shall be . . . deprived of life, liberty, or property, without due process of law.”770 Justice William O. Douglas notably explained that in bankruptcy, “[s]afeguards were provided to protect the rights of secured creditors, throughout the proceedings, to the extent of the value of the property. There is no constitutional claim of the creditor to more than that.”771 Commentators and practitioners have interpreted Justice Douglas’s explanation in a variety of ways, with some suggesting that it means that a secured creditor is only entitled to the liquidation value of its interest in the debtor’s property in bankruptcy, and others suggesting a broader meaning. Still another perspective is articulated by Prof. Tabb, who concludes that “a Fifth Amendment takings analysis simply is not helpful or indeed even applicable when considering the nature and scope of the protection constitutionally due to secured creditors in bankruptcy.”772 The value of a secured creditor’s interest in the debtor’s interest in property is relevant at various points in the chapter 11 case. As explained above in the context of adequate protection, section 506(a) provides in relevant part that “[s]uch value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property, and in conjunction with any hearing on such disposition or use or on a plan affecting such creditor’s interest.”773 The valuation of a secured 16 creditor’s claim thus involves at least two questions, both of which can provoke0litigation: What is 1, 2 ber 2 the appropriate valuation standard for the property included in theNovem creditor’s collateral, and on secured iv d chofethe secured creditor’s interest in such what is the appropriate standard for determining the 63 ar value 353 . 14- third issue concerning the appropriate valuation collateral under that standard? It also can ,raise a No own v. Brflow, precedent sale transactions, and comparable company methodology — e.g., discountedth e cash Blixs analysis. ed in cit Courts have taken different approaches to questions of valuation in chapter 11. Some courts suggest that liquidation value is always an appropriate standard for determining the value of the secured creditor’s interest in collateral because the debtor is operating in bankruptcy. Other courts apply a liquidation standard when valuing claims in chapter 7, and a going concern standard in reorganizations under chapter 11 on the theory that the valuation should be based on how the collateral is being used. Still other courts struggle with whether a liquidation standard, if appropriate, should be analyzed on a forced-sale or orderly-sale basis. The uncertainty surrounding valuation issues generates both litigation and, arguably, consensual resolutions. In the plan context, chapter 11 encourages consensual resolutions and permits parties to agree to distributions under a chapter 11 plan that may modify or otherwise affect their rights against the estate. Sections 1126 and 1129 codify this concept by providing that if the debtor proposes to impair the rights of a class of creditors or interest-holders under the plan and that impaired class accepts 769 770 771 772 U.S. Const. art. I, § 8, cl. 4. Id. amend. V. Wright v. Union Cent. Life Ins. Co., 311 U.S. 273, 278 (1940). Tabb, The Bankruptcy Clause, the Fifth Amendment, and the Limited Rights of Secured Creditors in Bankruptcy, supra note 115, at *1 (arguing that the “Fifth Amendment Takings Clause does not and should not constrain the power of Congress to modify the substantive rights of secured creditors under the Bankruptcy Clause.”). 773 11 U.S.C. § 506(a).  VI. Proposed Recommendations: Exiting the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 219 of 402 ABI Commission to Study the Reform of Chapter  the plan, the proposed treatment of the claims or interests is permissible even if it provides those creditors or interest-holders with arguably less than otherwise required.774 If an impaired class of claim- or interest-holders, however, does not accept the plan, the debtor can impose the proposed treatment on the class only if the plan satisfies the cramdown provisions of section 1129(b) of the Bankruptcy Code, including the absolute priority rule.775 The absolute priority rule as applied under Section 1129(b) in essence provides that a dissenting class of creditors must be paid in full before junior creditors or interest-holders may receive any distributions under the plan. The rule originates from the railroad equity receivership cases in the early 1900s and the U.S. Supreme Court’s decision in Northern Pacific Railway Co. v. Boyd.776 In that case, the railroad company reorganized by selling itself to bondholders and equity security holders and providing no distributions to junior creditors. The Supreme Court rejected this scheme and held that “[i]f the value of the [rail]road justified the issuance of stock exchanged for old shares, the creditors were entitled to the benefit of that value, whether it was present or prospective, for dividends or only for purposes of control.”777 The absolute priority rule codified in section 1129(b) is a variation of the rule announced by the Supreme Court in Boyd, but it continues the basic tenet that priority matters — i.e., secured creditors have a right to receive payment in full prior to junior creditors and interest-holders receiving any value. Section 1129(b) also articulates an application of the absolute priority rule for secured claims, 6 which preserves those payment rights in the waterfall payment scheme 21, a 01 of 2 chapter 11 plan. As one ber v m commentator noted shortly after the enactment of the BankruptcyeCode, “the [absolute priority] test n No ed o hiv for secured claims is completely novel, affording6protection for classes of secured claims that is not 3 arc -353 o. 14 provided under present law.”778 n, N h v. xset n Bli i Brow The absolute priority rule is an important creditor protection in chapter 11 cases, but it also has proven cited to be inflexible and often a barrier to a debtor’s successful reorganization. It also can allocate value among creditors in an arguably random manner depending on the timing of the value realization event — i.e., plan confirmation. For example, to the extent that a plan is confirmed during a downturn in the economy generally or the debtor’s industry more specifically, the valuations used to support the plan distributions may value the reorganized entity at a low point in the valuation cycle. Creditors may not have an appetite for, or the debtor may not have the financial ability to, continue to operate in chapter 11 until the valuation improves, or the debtor may not have the ability to offer adequate protection to secured creditors for the use of cash collateral or to obtain DIP financing, which may limit (or allow the secured creditor to limit) the duration of the case. Accordingly, under the absolute priority rule, junior creditors and interest-holders may lose their rights against the estate and receive no value on account of their claims simply because of the timing of the valuation of the enterprise in the chapter 11 case, while secured creditors, whose rights outside of bankruptcy 774 Id. §§ 1126, 1129(a). 775 Id. § 1129(a), (b). For a discussion of the “no unfair discrimination” requirement of section 1129(b), see Section VI.B, Approval of Section 363x Sales. 776 N. Pac. Ry. Co. v. Boyd, 228 U.S. 482 (1913). 777 Id. at 507–08. See also Ecker v. W. Pac. R.R. Corp., 318 U.S. 448 (1943); Marine Harbor Props., Inc. v. Mfrs. Trust Co., 317 U.S. 78 (1942); Consol. Rock Prods. Co. v. Du Bois, 312 U.S. 510, 520 (1941); Case v. L.A. Lumber Prods. Co., 308 U.S. 106, 122 (1939) (noting that Boyd adopts an absolute priority rule). 778 Klee, All You Ever Wanted to Know About Cram Down Under the New Bankruptcy Code, supra note 759, at 143 (citations omitted). VI. Proposed Recommendations: Exiting the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 220 of 402 Bankruptcy Institute would have been limited to foreclosure, get the benefits of the chapter 11 case and the exclusive right to the future possibilities of the firm as a reorganized going concern. Notably, similar valuation and distribution issues may arise in the context of a sale of all or substantially all of a debtor’s assets under section 363(b) and proposed section 363x under these principles. Although the price being offered for a debtor’s assets in a section 363 sale arguably reflects the current market value of those assets, to the extent the market is dysfunctional at the time of the sale, or economic or industry factors are negatively impacting valuations, the debtor’s estate may be monetized at value far below what the estate could be worth at a later date to the prejudice of stakeholders lower in the pecking order of priorities. The arguable unfairness of this result is potentially intensified when the secured creditor is the purchaser of the assets, for example using a credit bid, and is able to capture the future increments in value solely for its own benefit. Creditors’ Rights to Reorganization Value and Redemption Option Value: Recommendations and Findings Throughout their deliberations, the Commissioners held lengthy and thoughtful discussions concerning the rights of senior creditors in bankruptcy and how best to balance these rights with the reorganization needs of the debtor and the interests of other stakeholders.779 The Commissioners analyzed changes and trends in the secured lending industry and financial markets generally.780 They 16 1, 20 considered credit pricing and its relation to collateral valuations and riskeassessments.781 And they b r2 vem n No reviewed the literature representing all sides of these issues, including the commentary and studies ed o hiv on the perceived increase in senior creditor control5in 3 arc 6 chapter 11 cases.782 -3 3 . 14 , No rown B h v. 779 See Written Statement of A.J. Murphy: tLSTA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (Oct. 17, xse n Bli of secured creditors’ rights and the need for certainty for the capital markets when debtors i 2012) (describing the importance cited are in bankruptcy), available at Commission website, supra note 55; Written Statement of Lee Shaiman: LSTA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (Oct. 17, 2012) (same), available at Commission website, supra note 55; Written Statement of Michael Haddad, President of the Commercial Finance Association: CFA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (Nov. 15, 2012) (stating that secured creditors need certainty that their prepetition contractual agreements will be upheld in bankruptcy and that significant changes to this certainty will cause the cost of credit to increase), available at Commission website, supra note 55. 780 See, e.g., Written Statement of Ted Basta on behalf of LSTA: LSTA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 4 (Oct. 17, 2012) (“The primary leveraged loan market has grown dramatically in the last 10 to 15 years.”), available at Commission website, supra note 55; Written Statement of A.J. Murphy: LSTA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 1 (Oct. 17, 2012) (“Secured lending is a critical part of the capital markets, particularly for non-investment-grade borrowers. Indeed, virtually 100% of leveraged loans are secured, and secured debt makes up 50% of the leveraged finance market as a whole.”), available at Commission website, supra note 55. 781 See, e.g., Written Statement of Ted Basta on behalf of LSTA: LSTA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 7 (Oct. 17, 2012) (“Senior secured loans sit atop the capital structure of corporations — situated above high yield bonds, convertible securities, preferred stock, and common stock — and offer corporate America a private and cheaper source of funding than would otherwise be available. Because of the senior secured nature of leveraged loans, and the protections afforded to secured lenders, investors are willing to accept a far lower yield on their investment. For example, over the last three years, leveraged B-rated loans have been priced in the primary market — that is, they yield — approximately 200 basis points less than B-rated unsecured bonds, with this substantial savings (25%) passing directly to the borrower.”), available at Commission website, supra note 55; Written Statement of A.J. Murphy: LSTA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 2 (Oct. 17, 2012) (“By providing collateral for a loan, borrowers have the option of providing their lenders with a lower-risk basis on which to extend credit, in exchange for which the borrower obtains capital at a lower price. Indeed, non-investment-grade borrowers essentially have no access to the unsecured loan market, and absent secured loans, would be forced to issue high-yield bonds or risk being shut out of access to the capital markets altogether. Borrowing on an unsecured basis at extraordinarily punitive interest rates — or being denied credit altogether — may do far more harm to a company than borrowing at more reasonable rates on a secured basis.”), available at Commission website, supra note 55. 782 Written Statement of Lawrence C. Gottlieb, Partner, Cooley LLP: NYIC Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 4 (June 4, 2013) (noting that the adequate protection rules are increasingly resulting in retailer liquidation because substantially all of a distressed retailer’s assets are subject to prepetition liens and because of the adequate protection provision, debtors may not use or sell their assets without the lender’s consent; and lenders are not consenting), available at Commission website, supra note 55. See generally Kenneth M. Ayotte & Edward R. Morrison, Creditor Control and Conflict in Chapter 11, 1 J. Legal Analysis 511, 523 (2009); Barry E. Adler, Bankruptcy Primitives, 12 Am. Bankr. Inst. L. Rev. 219, 239 (2004) (“Chapter 11 is not for every firm, and the Bankruptcy Code should not permit chapter 11 to be an option for a debtor with a  VI. Proposed Recommendations: Exiting the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 221 of 402 ABI Commission to Study the Reform of Chapter  As discussed more fully in the context of adequate protection above, the Commissioners recognized the competing interests at stake and that the extreme position on either the pro-senior creditor or the pro-residual stakeholder side was not in the best interests of chapter 11 or the bankruptcy system. They strived to reach an appropriate balancing of these interests to the greatest extent possible. That balancing provides for valuing a senior creditor’s collateral at (i) foreclosure value (as defined in these principles) for purposes of adequate protection, and (ii) reorganization value (as defined in these principles) for purposes of distributions in the case. The Commissioners believed that this balance would enhance a debtor’s ability to obtain much-needed liquidity early in the case while allowing the senior creditor to benefit from the reorganized debtor’s continued use of collateral in the ongoing business by receiving the value of its collateral on an enterprise or going concern basis later in the case. They also found that it comported with the mandate of section 506(a) that “[s]uch value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property.”783 The definition of reorganization value in these principles is designed to capture the total enterprise value of the firm, including value generated through the chapter 11 case. Subject to the principles regarding redemption option value described below and the courts’ powers under sections 506(c) and 552(b), as described in Section VI.C.3, Section 506(c) and Charges Against Collateral and Section VI.C.4, Section 552(b) and Equities of the Case, the principles further provide that a senior creditor should be entitled to receive the reorganization value of its collateral under a chapter 11 plan or in a section 363x sale. 16 1, 20 ber 2 e The Commission received substantial testimony on the allocationvofm n No value in chapter 11 cases. Several ed o witnesses posited that chapter 11 cases were beingarchiv for the benefit of the senior creditors and 3 run 3536 784 785 . 14generating little, if any, value for other No , creditors. Commentators have also observed this trend. rown B h v. xset n Bli an alternative process in the event of default.”); Douglas G. Baird & Robert K. Rasmussen, Private i corporate charter ithat provides c ted Debt and the Missing Lever of Corporate Governance, 154 U. Pa. L. Rev. 1209, 1211 (2006) (discussing increased role of creditors in chapter 11 process); David A. Skeel, Doctrines and Markets: Creditors’ Ball: The “New” New Corporate Governance in Chapter 11, 152 U. Pa. L. Rev. 917, 918 (2003) (“Whereas the debtor and its managers seemed to dominate bankruptcy only a few years ago, Chapter 11 now has a distinctively creditor-oriented cast.”). But see Westbrook, The Role of Secured Credit in Chapter 11 Cases, supra note 750, at *1 (forthcoming 2015) (stating that “secured creditor control is less pervasive than has been asserted”). 783 11 U.S.C. § 506(a). 784 See, e.g., Oral Testimony of Bryan Marsal: NCBJ Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 19 (Oct. 26, 2012) (NCBJ Transcript) (“I think what you’ve got today is that because of the move from being unsecured creditor status to secured creditor status, which is happened over the last number of years that I’ve been in the business, it’s increased the leverage of the secured creditors and thus reduced the flexibility of a rehabilitation during this process.”), available at Commission website, supra note 55; Statement of John Haggerty, Argus Management Corp.: ASM Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 1–2 (Apr. 19, 2013) (“Over the years the secured lenders have increased their control over the company during the pre-petition period by taking dominion of the cash via lockbox sweeps; and requiring strict budgets and forbearance agreements. These actions enable the secured creditor to significantly increase their control over borrower cash and ultimately over a Chapter 11 filing should the borrower choose to go that route.”), available at Commission website, supra note 55; Written Statement of Jim Millstein, Chairman of Millstein & Co.: ASM Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 2 (Apr. 19, 2012) (“[B]y virtue of the significant protections afforded secured debt under Chapter 11, sophisticated creditors take pains to structure their credit extensions in secured form when lending to companies in distress. As a result, in cases where the aggregate amount of secured debt exceeds the going concern value of the enterprise, a Chapter 11 reorganization has become little more than a court-supervised assignment for the benefit of creditors.”), available at Commission website, supra note 55; Written Statement of Clifford J. White, Director, Executive Office for the U.S. Trustees: ASM Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (Apr. 19, 2012) (describing how DIP lending conditions often ultimately control the fate of the debtor), available at Commission website, supra note 55; Oral Testimony Ted Basta on behalf of LSTA: LSTA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 13 (Oct. 17, 2012) (LSTA Transcript) (noting that secured creditors have great influence over DIP lending terms), available at Commission website, supra note 55. See also Tabb, The Bankruptcy Clause, the Fifth Amendment, and the Limited Rights of Secured Creditors in Bankruptcy, supra note 115, at *3–4 (“One of the most notable developments in chapter 11 reorganization practice in this millennium is the dramatic expansion in the power exercised by secured creditors. Financing has experienced a sea change, and today many firms enter chapter 11 with their assets full (or almost fully) encumbered. The reality then is that the entire reorganization is dependent on the good graces of the prebankruptcy controlling secured lender. That means that important stakeholders — bondholders, trade creditors, tort victims, employees, and shareholders, to name but a few — are excluded from any recovery but for the whims of the controlling secured creditor.”). 785 See, e.g., Jacoby & Janger, Ice Cube Bonds, supra note 283, at 922–23 (discussing lender control exerted over timing of sales through postpetition financing and blanket liens); Anthony J. Casey, The Creditor’s Bargain and Option-Preservation Priority in Chapter 11, 78 U. Chi. L. Rev. 759, 760 (2011) (“A secured creditor, exercising control over the debtor firm, determines that VI. Proposed Recommendations: Exiting the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 222 of 402 Bankruptcy Institute Similarly, witnesses expressed concerns regarding the lack of a debtor’s equity in its property at the commencement of its case and the challenges presented to restructuring the debtor under these circumstances.786 The Commission also heard testimony concerning how the timing of a chapter 11 case — and the value realization event in the case (e.g., plan confirmation or sale approval) — can impact value allocations among creditors, and also how capital structures overwhelmed by secured debt and a resulting difficulty in obtaining postpetition financing to continue operations are creating increasing pressure to monetize the assets of the debtor’s estate through quick section 363 sales.787 The Commissioners debated both the underlying premises in this testimony, as well as possible ways to address the concerns.788 The Commissioners noted the increasing concerns among commentators and practitioners regarding administratively insolvent chapter 11 cases, structured dismissals, and issues regarding value allocation in chapter 11 cases.789 They observed that in the recent cycle of chapter 11 cases, the fulcrum security (i.e., the priority level of the class of debt in the debtor’s capital 786 787 788 789  a bankruptcy filing to facilitate such a sale is the optimal strategy for the distressed firm. The debtor then files, and the sale is accomplished”). See Written Testimony of Michael R. (“Buzz”) Rochelle: UT Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 1 (Nov. 22, 2013) (“Today the newly-filed debtor is already under water; the secured lender is under-secured; and use of cash collateral generally comes with concessions that tighten security documentation and tie the debtor to a short-term budget which allows for little but locating an asset purchaser.”), available at Commission website, supra note 55; Written Statement of Kathryn Coleman, Attorney at Hughes Hubbard & Reed, LLP: TMA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 3, 4–5, 6 (Nov. 3, 2012) (stating that secured creditors have often “liened up” all the debtor’s assets prior to the bankruptcy, hurting the debtor’s chance at rehabilitation), available at Commission website, supra note 55. “Lenders providing postpetition financing no longer do so in order to make good returns with assured repayment, or protect their prepetition 16 positions by getting collateral for previously unsecured loans. Instead, they often do so in order 1, 20 control of the debtor, to take ber 2 through covenants, deadlines, and default provisions.” Id. ovem See, e.g., Written Statement of Professor Anthony J. Casey: CFRP Field Hearing on N the ABI Comm’n to Study the Reform of ed Before foreclosure and liquidation rights when Chapter 11, at 3 (Nov. 7, 2013) (“On the other hand, the secured creditor chiv exercise its ar may the debtor defaults. But that liquidation cuts off the future 4-35363 as part of a going concern. Thus, the secured creditor’s of the assets claim on going concern is extinguished along withn, Njunior creditors’ claims. The secured creditor essentially has two options: the o. 1 r w take the liquidation value or keep the firm aliveosubject to the junior creditors’ claims.”), available at Commission website, supra v. B note 55; Written Statement of Sandra E.th ixse Horowitz: VALCON Field Hearing Before the ABI Comm’n to Study the Reform of Chapter n Blthird challenge confronting creditors’ committees is the growing use of quick Section 363 asset i 11, at 3 (Feb. 21, 2013) (“Finally, a cited sales, a situation that can undermine their efforts to maximize recoveries for general unsecured creditors. While I recognize that a sale can be viewed as the real value of the estate and the only viable option, I would argue that this alternative can benefit the DIP lenders and possibly other secured creditors to the complete detriment of the unsecured credits who may well benefit from a classical operational and financial restructuring from which value can ultimately be realized.”), available at Commission website, supra note 55. Notably, the Commission also received and considered at length testimony on the value of secured credit in bankruptcy and the important role markets play in providing liquidity to distressed companies. See, e.g., Oral Testimony of Elliot Ganz: LSTA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 1 (Oct. 17, 2012) (“There are two things that are especially important to the smooth functioning of the market, legal clarity and financial liquidity. First, lenders and investors need to know what the rules are prior to entering into a transaction. They need to have the confidence that the rights they’ve bargained for will be respected and enforced. Second, they need to know that they have the ability to sell their positions, especially when things go south.”), available at Commission website, supra note 55; Written Statement of A.J. Murphy: LSTA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 2-3 (Oct. 17, 2012) (“Secured credit is also vital when the capital markets constrict, as they did just a few years ago in the aftermath of the 2008 financial crisis. At that time, when leveraged markets were barely functioning, investors were extraordinarily (and understandably) careful about investing in non-investment-grade debt. At the same time, due to the economic downturn, many companies were facing challenges to their businesses and needed capital just as the markets were freezing up. For a very large number of those companies, the solution was to access the secured debt markets.”), available at Commission website, supra note 55; Written Statement of Lee Shaiman: LSTA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 2 (Oct. 17, 2012) (“[L]essening the protections accorded secured creditors would affect loan sizes going forward. Lenders would not be willing to lend as much if they cannot be sure that they will be able to collect as much as they are owed or the value of their collateral in the event of default.”), available at Commission website, supra note 55; Written Statement of Michael Haddad, President of the Commercial Finance Association: CFA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 1 (Nov. 15, 2012) (“Asset-based financing extended by CFA members has played an important role in financing the growth of U.S. companies for many decades. It allows companies the opportunity to obtain the working capital they need to operate and grow, and create jobs, and also provides financing for capital expenditures and the acquisition of other companies.”), available at Commission website, supra note 55. Throughout deliberations — on all issues — the Commission worked to balance competing interests and perspectives. See, e.g., Nan Roberts Eitel, T. Patrick Tinker & Lisa L. Lambert, Structured Dismissals, or Cases Dismissed Outside of Code’s Structure?, Am. Bankr. Inst. J., Mar. 2011, at 20; Bruce S. Nathan & Bruce D. Buechler, Who Pays the Freight? Interplay Between Priority Claims and a Debtor’s Secured Lender, Am. Bankr. Inst. J., Nov. 2011, at 26; Norman L. Pernick & G. David Dean, Structured Chapter 11 Dismissals: A Viable and Growing Alternative after Asset Sales, Am. Bankr. Inst. J., June 2010, at 1; Charles R. Sterbach & Keriann M. Atencio, Why Johnny Can’t Get Paid on His General Unsecured Claims: a Potpourri of Lingering Abuses in Chapter 11 Cases, 14 J. Bankr. L. & Prac. 1, Art. 3 (2005). VI. Proposed Recommendations: Exiting the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 223 of 402 ABI Commission to Study the Reform of Chapter  structure at which the firm’s enterprise value is exhausted at the time of the enterprise valuation in the case) was higher in the debtor’s capital structure than in the past. Although in 1978 the fulcrum security was almost always general unsecured claims, in more recent cycles, the fulcrum security was increasingly often at the senior creditor or subordinated senior creditor level.790 The Commissioners discussed the potential reasons for this trend, including the testimony from the lending community on these issues.791 They acknowledged the potential role of various confounding factors such as economic cycles, lending practices, delay in commencing chapter 11 cases (which can be facilitated by the economic cycle and the availability of cheap money, as well as a management’s resistance to a filing), outdated or underperforming business models, ineffective management, and other market or constituent pressures. They also recognized and discussed the arguments of commentators and practitioners who believe that value allocation and creditors’ recoveries should remain relatively unchanged and are appropriate given parties’ state law rights.792 The Commission 790 See, e.g., Oral Testimony of Bryan Marsal: NCBJ Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 22 (Oct. 26, 2012) (NCBJ Transcript) (“If you just looked at the Lehman example, you see that at the 11th hour, various sophisticated creditors went from unsecured status to secured status and, in fact, used the safe harbors to the tune of $17 billion. The answer is more sophisticated the creditor, in this case, would be your banker. Your banker has an opportunity to take advantage of all other classes of creditors by moving effectively from unsecured status to secured status. That’s happened in Lehman, and it happens every day.”), available at Commission website, supra note 55; Written Statement of Honorable Melanie L. Cyganowski (Ret.), former Chief Bankruptcy Judge, Eastern District of New York: CFA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 2 (Nov. 15, 2012) (“In the middle market cases, it is the secured debt that is the fulcrum credit.”), available at Commission website, supra note 55. See also Christie Smythe, “Fulcrum” Deals Rising to Prominence, Experts Say, Law 360 (Oct. 9, 2009, 1:26 PM) (“While in the past fulcrum securities were generally unsecured bonds, secured bonds have also become 16 fulcrum securities in some recent bankruptcy scenarios as a result of the lending practices before0 credit crisis, experts said.”), 1, 2 the ber 2 available at http://www.law360.com/articles/122360/fulcrum-deals-rising-to-prominence-experts-say. ovem 791 See, e.g., Written Statement of Ted Basta on behalf of LSTA: LSTA Field d on N Before the ABI Comm’n to Study the Reform of e Hearing Chapter 11, at 10 (Oct. 17, 2012) (“During the financial crisis of 2008-2009, primary markets for both leveraged loans and high rchiv 63 a yield unsecured bonds seized up (illustrated on Slide 353Importantly, the senior secured high yield bond market increased - 6). . 4 dramatically to take up some of the slack, providing1crucial liquidity that was otherwise unavailable. In 2007, leveraged lending , No rown volume plunged from $535 billion to $152 billion and $76 in 2008 and 2009, respectively. Similarly, unsecured high yield bond B h v. volume fell from $143 billionset2007 to $68 billion in 2008, before recovering to $163 billion in 2009. Despite the precipitous x in n Bli unsecured high yield bonds, secured high yield bond volume moved to fill the void in 2009, with decline in leveraged d i and loans cite issuance of $60 billion, a ten-fold increase from 2008, and a four-fold increase from 2007, when respective volume was $6 billion and $15 billion.”), available at Commission website, supra note 55; Oral Testimony of A.J. Murphy: LSTA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 28 (Oct. 17, 2012) (transcript) (“What I would say is, we’ve definitely seen an increase in percentages of debt raised in the high-yield bond that’s secured, so you’re probably talking about 25% of the highyield bond market having any kind of security around it back in ‘06. Today you’re in the low 30s, and we peaked about 34–35% number, so it definitely picked up by about 10% during that period of time, and it was noticeable because the debt overall in the bond market was down then, so it felt like there were so many bond issuers in there, and there were because that was how you raised capital. . . . I would say that the other side of that equation was there was no loans being issued for the most part, so the secured bonds in no way filled the hole that was left behind by the loans that were not being raised. The loan market has been recovering pretty steadily, more or less, for the last three years now, but I don’t know that we are back to where we were in that Golden Day of the CLO.”), available at Commission website, supra note 55. 792 See, e.g., Written Statement of Ted Basta on behalf of LSTA: LSTA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 8 (Oct. 17, 2012) (“Since bank loans are typically the most senior debt in a company’s capital structure, and generally have first lien claim to a company’s assets in the event of bankruptcy, they fare far better upon default than other indebtedness. Moreover, that level of recovery has stayed remarkably consistent over the last four credit cycles. According to an analysis by Moody’s Investor Services, which tracked more than 1,000 corporate defaults since January 1987, average recoveries for bank loans were approximately 80 cents on the dollar, compared with recovery of less than 50 cents on the dollar for senior unsecured bonds and 30 cents on the dollar for subordinated bonds.”), available at Commission website, supra note 55; Written Statement of A.J. Murphy: LSTA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 2 (Oct. 17, 2012) (“[F]ocusing only on the debtors that fail to reorganize in chapter 11 ignores the far greater number of companies who avoid bankruptcy entirely, and instead develop their businesses and create jobs, because they are able to access low-cost, secured credit. The ability to pledge collateral is particularly vital to both healthy non-investment-grade and financially distressed companies. In both cases, the security interest is a critical tool in reducing the cost of credit, and in many cases is a necessary condition to the extension of credit at all. Without the ability to offer an enforceable security interest, non-investment-grade borrowers may lack sufficient access to the capital markets.”), available at Commission website, supra note 55; Written Statement of Lee Shaiman: LSTA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11 (Oct. 17, 2012) (“[B]ankruptcy reforms will not affect bankruptcy alone. Weakening the protections available to secured creditors, or reducing the recovery of holders of debt bought on the secondary market, will have a profound, and negative, effect on the availability and price of credit — particularly credit extended to non-investment-grade companies.”), available at Commission website, supra note 55; Oral Testimony of Lee Shaiman: LSTA Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 27 (Oct. 17, 2012) (transcript) (“If you look at capital structures 10 years back and the ratios of senior secured debt to subordinated debt I would suspect that, in general, that those capital structures are not dramatically different.”), available at Commission website, supra note 55; Written Statement of Michael Haddad, President of the Commercial Finance Association: CFA Field Hearing Before the ABI Comm’n to Study the VI. Proposed Recommendations: Exiting the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 224 of 402 Bankruptcy Institute ultimately concluded that trying to isolate the cause was futile and that a better approach would be to explore ways to enhance the value allocation rules and distribution mechanisms in chapter 11 so as to continue to protect the rights of senior creditors, protect junior creditors against being cut off entirely from the future possibilities of the firm based on a valuation at a single moment in time and based on other factors that may be outside of the debtor’s control, and incentivize the major parties to reach a consensual reorganization if the underlying economics justified the debtor’s emergence as an ongoing enterprise. The Commissioners worked extensively to identify ways to achieve these goals. The Commission generally agreed that the timing of a judicially supervised reorganization in the life cycle of the credit markets generally and in the business life cycle of a given company should not dictate hard and fast distributional rules that advantage the creditors who happen to be in the senior position at a given moment in time.  The Commissioners discussed this basic premise at length and the concept that a valuation date set by the effective date of a plan or the date of a section 363x sale order should not cut off all future possibilities associated with the affected assets for a junior class that appears to be significantly impaired or out of the money on the plan or sale valuation date. Accordingly, the Commission determined to recommend the following overarching principle: the general priority scheme of chapter 11 should incorporate a mechanism to determine whether distributions to stakeholders should be adjusted due to the possibility of material changes in the value of the firm within a reasonable period of time after the plan effective date or section 363x sale order date, as 16 1 20 the case may be, which would enable junior creditors to “redeem” in fullethe ,allowed claim of the b r2 m impaired senior creditors receiving the reorganization value of d on company under such plan or sale. the Nove ive arch 363 -35 o. of Under this principle, even if an impaired ,class14 senior creditors would otherwise be entitled to n N row the entirety of the reorganizationth v. B of the firm based on its reorganization value on the effective value lixse nB date of the plan or date iof the 363x sale order, the court should not confirm the plan over the cited non-acceptance of the immediately junior class or approve a sale under section 363x that is not objected to by members of the immediately junior class, as the case may be, unless the plan or the order approving the section 363x sale, as applicable, provides for an allocation of redemption option value to the immediately junior class to the extent of its entitlement thereto as described in the principles above.793 Specifically, a chapter 11 plan may be confirmed (a) over the non-acceptance of the immediately junior class if and only if such immediately junior class receives not less than the redemption option value, if any, applicable to such class, and (b) over the non-acceptance of a Reform of Chapter 11, at 3 (Nov. 15, 2012) (“If the Commission ultimately proposes reducing the rights of secured lenders in Chapter 11, then it is our organization’s view that anything short of allowing secured lenders the ability to obtain the benefits provided under their pre-chapter 11 loan agreements in Chapter 11 will have the direct effect of increasing our members’ risk analysis which will result in increasing the cost of credit and reducing the amount of credit extended to SME borrowers who seek relief under Chapter 11.”), available at Commission website, supra note 55. 793 For a thoughtful analysis of “option” value in chapter 11 cases, see Casey, supra note 785 (explaining value distortions created by the creditors’ bargain and strict adherence to the absolute priority rule, and proposing a creditors’ call option to address such valuation distortions). See also Douglas G. Baird & Donald S. Bernstein, Absolute Priority, Valuation Uncertainty, and the Reorganization Bargain, 115 Yale L.J. 1930, 1936 (2006) (“The presence of valuation uncertainty can, by itself, give option value to the claims of junior creditors even when they are, in expectation, out of the money.”) It should be noted that Professor Casey talks about preserving secured creditors’ nonbankruptcy foreclosure value. See Casey, supra note 785, at 789 (“The creditors’-bargain model requires a distributional rule that — while respecting nonbankruptcy contract rights — maximizes the aggregate pool of assets in bankruptcy. This means protecting the secured creditor’s right to nonbankruptcy foreclosure value and the unsecured creditor’s call option, while allocating bankruptcy rights in a way that creates the optimal incentives for the creditors. The proposed Option-Preservation Priority does precisely that.”). The Commissioners debated the “foreclosure” vs. “reorganization” value issue at length and the Commission determined that, as part of the overall compromise reached in the principles, if a plan is confirmed or a sale is approved, secured creditors should be permitted to receive the reorganization value of their collateral, which could be greater than the nonbankruptcy foreclosure value.  VI. Proposed Recommendations: Exiting the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 225 of 402 ABI Commission to Study the Reform of Chapter  senior class of creditors, even if the senior class is not paid in full within the meaning of the absolute priority rule, if the plan’s deviation from the absolute priority rule treatment of the senior class is solely for the distribution to an immediately junior class of the redemption option value, if any, attributable to such class. Notwithstanding the foregoing, however, if a chapter 11 plan is rejected by the immediately junior class and such class challenges the reorganization value used to determine such class’s entitlement to redemption option value under such plan, the plan should be confirmed over the non-acceptance of such immediately junior class if (i) the court finds, based on the evidence presented at the confirmation hearing, that such reorganization value was not proposed in bad faith, and (ii) the plan satisfies, with respect to such immediately junior class, the requirements of section 1129(b) other than the requirement that reorganization option value be provided to such class. Similarly, section 363 should be amended to provide that, in the context of a section 363x sale, if the members of an immediately junior class do not object to the sale, the immediately junior class should be entitled to receive from the reorganization value attributable to such sale not less than the redemption option value, if any, attributable to such immediately junior class. If, however, the immediately junior class objects to the sale, they will not be entitled to such redemption option value. The Commission agreed that the principles governing redemption option value in chapter 11 cases should not apply to cases involving small and medium-sized enterprises. The Commission believed that further study and development of the principles would be needed to determine whether they 16 could be applied in a cost-effective and meaningful manner in such cases. 1, 20Commission proposed The ber 2 m separate principles governing confirmation of chapter 11 plans Nove n in small and medium-sized enterprise ed o iv arch cases, in Section VII, Proposed Recommendations:3Small and Medium-Sized Enterprise (SME) Cases. 536 -3 o. 14 n, N row In developing these principles, Bthe Commissioners discussed, debated, and refined several key th v. lixse in B concepts necessarydto determine whether distributions to stakeholders should be adjusted due to cite the possibility of changes of the value of the firm within a reasonable period of time after the plan effective date or section 363x sale order date, as the case may be. The Commission concluded that the redemption option value attributable to the immediately junior class should be the value of a hypothetical option to purchase the entire firm with an exercise price equal to the redemption price and a duration equal to the redemption period. Notably, value distributed to the immediately junior class under these principles need not be, and in most cases likely would not be, in the form of an actual option. The requirement is that the requisite value be distributed to the immediately junior class, regardless of form. Although a relatively straightforward concept in a simple capital structure (see example below), the Commissioners recognized the potential complexities of applying these principles in more involved corporate and financing structures. Accordingly, the Commissioners strived to identify principles that define the basic parameters of junior creditors’ rights, with the expectation that there would be further development of the appropriate mechanisms for applying the principles in more complex cases. Indeed, the principles set forth above are not intended to alter the order of creditor priorities or to affect allocations within a particular class of creditors; rather, the principles speak generally to how courts should determine whether the value of the debtor or its assets is sufficient to support a distribution to the immediately junior class. The Commissioners acknowledged that, in implementing the redemption option value concept, the mechanism invoked by the parties and the VI. Proposed Recommendations: Exiting the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 226 of 402 Bankruptcy Institute courts will likely require further development to determine whether and how it should be applied in more complex contexts, for example where a senior class is entitled to less than all of the firm’s enterprise value (for example where it is secured by only some of the assets of the firm), where contractual or structural subordination (rather than a lien) results in an immediately junior class, where there are multiple classes senior to the immediately junior class and not all senior classes are receiving distributions in the form of interests in the residual value of the firm, where only part of the immediately junior class objects to a sale or challenges reorganization value under a plan, or where some enterprise value is distributable at the current enterprise valuation to an immediately junior class, but the junior class is not being paid in full. In their discussions of redemption option value, the Commissioners methodically examined various formulas and procedures for addressing the potential deficiencies in chapter 11 valuations based on the timing of the effective date of the plan or the date of the section 363x sale order. For example, in a simple capital structure, the Commissioners considered the following factors and steps appropriate, and they are set forth here solely for purposes of illustration: First, the Commissioners analyzed the problem at hand — e.g., timing can cause the value realization event to allocate value among creditors at a historically low valuation. The Commissioners examined the economic and financial literature and determined that most economic cycles, industry events, operational issues, etc. resolve themselves 6 in approximately three to five years. Recognizing the need for eparties 1to have certainty 1, 20 b r2 em as soon as possible in the distribution context and despitevstrong arguments from some n No ed o rch decided to recommend using, as the Commissioners for five years, the Commission iv 63 a -353 expiration date of the exercisen, No. 14 for the hypothetical redemption option, a date period row v. Bpetition date. Based on several factors, including the factors that is three years fromhthe et Blixs discussed abovein the average duration of chapter 11 cases as shown in the chart below, ed and cit the Commission found that determining redemption option value based on a hypothetical option expiring at the end of such a three year period (the redemption period) should be sufficient to redress the potential unfairness of permanently crystalizing the value of the firm as of a single plan confirmation date or sale date.794 794 Mr. Shrestha prepared this chart for the Commission based on data from the New Generation’s Public and Major Private Companies Database. Accordingly, it was limited to public and large private companies. The duration above is from the petition date to the date of the confirmation order. In recent years, the mean and median durations for chapter 11 reorganizations (from petition date to confirmation) are respectively: 2009 (342, 275); 2010 (269, 206); 2011 (360, 338); 2012 (281, 274); 2013 (116, 108). See generally supra note 65 and accompanying text (generally discussing limitation of chapter 11 empirical studies).  VI. Proposed Recommendations: Exiting the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 227 of 402 ABI Commission to Study the Reform of Chapter  Nu ber of Days Before on r ation Year Bankruptcy Petition Filed DURATION BETWEEN BANKRUPTCY FILING AND CONFIRMATION ORDER 016 ,2 Second, the Commissioners evaluated different ways to calculate the redemption option er 21 emb Nov value — i.e., the potential value allocation to theoimmediately junior class at the time of d n chive the value realization event. After much 3 ar debate, including discussion of concerns of some 3536 . 14Nooption valuation methodology was not a good fit for the of the Commissioners thatn,an Brow th v redemption concept,. the Commission concluded that using a market-based method lixse in B c the such asited Black-Scholes model purely as a working formula would likely be the best way to consistently and accurately determine the value of the hypothetical redemption option. Traditionally, a Black-Scholes model uses four factors to value an option: the strike price of an option, the term of the option, volatility, and the risk-free rate. In the context of calculating any redemption option value, (i) the strike price is 100 percent of the redemption price described above (i.e., senior class or classes must be repaid in full before any redemption option value exists), (ii) the term of the option would expire three years from the petition date (i.e., the redemption period); (iii) volatility could vary but can be determined for a particular debtor by looking at the historical volatility of comparable companies, using an agreed upon volatility rate, or using a set metric like the average 60 day forward volatility of the S&P 500 Index for the past four years (i.e., approximately 15% at the time of this Report); and (iv) the risk-free rate generally is based on the U.S. Treasury rate.795 Third, the Commissioners tested the rule using the agreed upon calculation formula under a variety of scenarios. For example, if the senior class is entitled to the entire value of the firm and is determined to be receiving 50 percent of the principal amount of their 795 The Black-Scholes formula or similar methodologies could identify the redemption option value once these four factors are identified and the percentage recovery of the secured creditors based on the reorganization value of the firm is determined as of the plan confirmation or section 363x sale order date. The Binomial Options Pricing Model, Monte Carlo options models, and other formulas may have to be considered where Black-Scholes is not effective to value an option on a particular enterprise. VI. Proposed Recommendations: Exiting the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 228 of 402 Bankruptcy Institute claims (before giving effect to bifurcation of the their secured claims, if any, pursuant to section 506(a)) based on the reorganization value of the firm on a plan confirmation date as specified in the plan, and the confirmation date occurs one year after the petition date, the redemption option value likely holds no value for the immediately junior class under reasonable assumptions. Specifically, this result occurs with a 50 percent recovery to the senior class; a “strike” price (the redemption price) of 100 percent (payment in full to the senior class); a redemption period of two years (confirmation date one year after the petition date); a volatility rate of 15  percent; and a risk-free rate of 2.23 percent. If you change the percentage recovery of the senior class to 90 percent, meaning that the reorganization value of the firm is sufficient to repay the senior creditors 90 percent of the principal amount of their claims (before giving effect to bifurcation of the their secured claims, if any, pursuant to section 506(a)), the redemption option value (under the previous assumptions) is approximately 5 percent of the reorganization value, which would be distributed to the immediately junior class. Specifically, this result occurs with a 90 percent recovery to the senior class; a “strike” price (the redemption price) of 100 percent (payment in full to the senior class); a redemption period of two years (confirmation date one year after the petition date); a volatility rate of 15 percent; and a risk-free rate of 2.23 percent. The following chart depicts these results: REDEMPTION VALUE CALCULATION BASED ON S&P 500 OPTION FORMULA 16 1, 20 ber 2 Additional Assumptions vem n No Risk-Free Rate: 2.23% ed o rchiv Term (years): 2 years remaining 63 a -353 . 14 Strike Price: 100% Recovery , No rown B h v. xset Volatility n Bli i cited Recovery % on Senior Debt 90.00 80.00 70.00 60.00 50.00 12.0% 3.84 1.11 0.18 0.01 0.00 15.0% 5.32 2.06 0.54 0.08 0.00 18.0% 6.83 3.15 1.10 0.25 0.03 Redemption Option Value as a % of Reorganization Value Notes The above option pricing uses Black-Scholes to determine value based on assumptions noted. Midpoint volatility assumption of 15% is based on 60D historical volatility for S&P 500 from July 2010 to present. Risk-Free Rate is based on US Treasury (2 Year) average yield from July 2000 to present. Bottom-line implications of the redemption option value rule: Where the senior class’s distributions on the plan confirmation or sale order date are close to the full principal amount of their claims (before giving effect to bifurcation of the their secured claims, if any, pursuant to section 506(a)), the immediately junior class is likely to be entitled to some redemption option value. On the other hand, where the senior class is deeply impaired and its distributions on the plan confirmation or sale order date are low in comparison to the full amount of the senior class’s claims, the immediately junior class is likely to be entitled to receive little or nothing. Likewise, the time remaining on the redemption period (i.e., three years from the petition date) could affect the redemption option value, with a longer period working in favor of some redemption option value (but not necessarily in all cases, as  VI. Proposed Recommendations: Exiting the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 229 of 402 ABI Commission to Study the Reform of Chapter  again the initial percentage recovery for the senior class greatly influences the calculation). Volatility and the risk-free rate can also impact the calculation, but likely less so than the other two factors in the redemption option value context. Moreover, as indicated in the principles, the class entitled to receive the redemption option value generally will be the class immediately junior to the fulcrum security class, assuming that the fulcrum security class is the principal beneficiary of the residual value of the firm under the plan. Note: Redemption option value only exists if the senior class would receive the full face amount of the claims of the senior class, including any unsecured deficiency claim, plus any interest at the non-default contract rate plus allowable fees and expenses unpaid by the debtor, in each case accruing through the hypothetical date of exercise of the redemption option, as though the claims remained outstanding on the date of the exercise of the option (i.e., the redemption price). If any redemption option value exists under the foregoing calculation as of the plan effective date or section 363x sale order date, it could be paid pursuant to the plan or section 363x sale order in the form of cash, debt, stock, warrants, or other consideration, provided that any non-cash consideration would be valued on a basis consistent with the manner in which reorganization value was determined. The form of consideration used to provide redemption option value to the immediately junior class should be subject to the election of the senior class being required to give up such value, regardless of whether such senior class has accepted the plan. If no redemption option value exists on that date (or such class is not otherwise entitled1to 016 , 2 receive any redemption er 2 emb option value under these principles), nothing furtherNov is required and no value is distributed d on to such junior creditors in the case. chive 3 ar 536 14-3 No. As explained above, the Commission, recommended the addition of the redemption option value wn . Bro eth v rule to the general priority scheme of the Bankruptcy Code as a minimum entitlement for the ixs in Bl cited immediately junior class based on the reorganization value of the firm as of the plan effective date or section 363x sale order date. The Commissioners believed that adding the redemption option value rule would appropriately balance the competing issues at stake in the context of value realization events in a case while respecting the value of the senior creditors’ interest in the debtor’s property.796 As suggested by the principles, the redemption option value rule would apply in both the chapter 11 plan and section 363x sale process.797 The Commissioners discussed the potential challenges to 796 Tabb, The Bankruptcy Clause, the Fifth Amendment, and the Limited Rights of Secured Creditors in Bankruptcy, supra note 115, at *5 (“Outside of bankruptcy, the secured lender may have considerable difficulty capturing anything above liquidation value. If the bankruptcy process itself allows the recovery of more value, why should all of that bankruptcy-enabled excess go to the secured lender.”). 797 For a thoughtful discussion of potential value distortion in chapter 11 sales, see Jacoby & Janger, supra note 283, at 894–95 (“This going-concern premium is a product of the federal bankruptcy regime. Sometimes, the going-concern premium can only be obtained by acting quickly. Thus, a Bankruptcy Code created speed premium exists (as part of the going-concern premium) when a quick sale is necessary to preserve value. While both premia are worth preserving, we are concerned that parties not be able to exploit the perceived need for speed to distort the Code’s distributional scheme.”). In addition, Professor Casey explains such potential value distortion as follows: Indeed, a recent study by Kenneth Ayotte and Edward Morrison shows that the outcomes of these sales are distorted by conflict between junior and senior creditors. This conflict stems from the mismatched incentives of the different classes of creditors. On the one hand, senior creditors have an incentive to sell the company in a quick sale even when reorganization has a higher expected return for the estate. Thus, when senior creditors are exercising control — which they do in most cases — the result is an inefficient fire sale of the debtor’s assets. On the other hand, junior creditors have an incentive to block the quick sale in favor of a drawn-out reorganization even when the sale has the higher expected return for the estate. Thus, in cases where the junior creditors can obtain some control — usually by prevailing on procedural objections — there may be a distortion in favor of an inefficient and prolonged reorganization. Casey, supra note 785, at 761–62 (citations omitted). VI. Proposed Recommendations: Exiting the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 230 of 402 Bankruptcy Institute applying the redemption option value rule in a section 363x sale process, particularly where the purchaser is a third party and not the senior class. In those situations, the redemption option value can still be calculated based on the net purchase price and parties can determine what, if anything, must be allocated to the immediately junior class. Some of the Commissioners were concerned, however, about paying the redemption option value when the senior class was not getting the future value of the firm per se. Other Commissioners noted that the senior class in these situations typically receives distributions and the benefits of the section  363x sale on a quicker timeline; from that perspective, the decision to sell forecloses the plan of reorganization alternative and the future value distributions that would flow from the reorganization. The Commission agreed that the estate — and not the third party purchaser — should be responsible for paying any redemption option value to the immediately junior class. (Of course, any such value paid from the estate will reduce the value available for the senior class.) They also recognized that excluding section 363x sales to third parties from the redemption option value rule could encourage gamesmanship and alternative deal structures that avoid the rule but effectively transfer the assets or their future value to the senior class. Likewise, excluding all section 363x sales could discourage reorganizations without addressing the important issues surrounding the timing of value realization events and value allocation in chapter 11 cases discussed above.798 On balance, the Commission voted to apply the redemption option value rule to plans and all section 363x sales (except in small and medium-sized enterprise cases), recognizing that in both the plan 16 1, 20 and the sale contexts, this default rule will likely encourage consensual resolutions that benefit all. ber 2 m The Commission also acknowledged that the redemption option Nove principles set forth in this n value ed o rc iv Report are essentially guidelines for courts and parties ato huse in developing such value allocation 63 -353 14 principles for more nuanced and complex ,capital structures than those vetted by the Commission. No. rown The Commission found greatlixseth v. B utility to the redemption value option, and it encourages the potential B ed in restructuring community and commentators to build upon this concept to more completely develop cit fair allocation rules in chapter 11 cases. 2. New Value Corollary Recommended Principles: A prepetition interest-holder, including an insider, should be permitted to retain or purchase an interest in the reorganized debtor without violating the absolute priority rule of section  1129(b)(2)(B)(ii) or section 1129(b)(2)(C)(ii) of the Bankruptcy Code, if applicable, provided that such interest-holder contributes new money or money’s worth to the debtor’s reorganization efforts in an aggregate amount that is reasonably proportionate to the interest retained or purchased and that is subject to a reasonable market test. 798 The Commissioners discussed similar considerations in determining that a secured creditors’ section 1111(b) election should not be operative under the redemption option value rule.  VI. Proposed Recommendations: Exiting the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 231 of 402 ABI Commission to Study the Reform of Chapter  New Value Corollary: Background As described in the preceding section, the absolute priority rule requires that senior classes of claims or interests be paid in full prior to junior classes receiving any distributions under the chapter 11 plan. Consequently, prepetition equity security holders generally cannot retain or receive new equity in the reorganized debtor unless all creditors are paid in full under the plan. This general rule predates the Bankruptcy Code and finds its origins in the equity receiverships of the early 1900s. As the U.S. Supreme Court explained in Boyd, “creditors [are] entitled to be paid before the stockholders could retain [equity] for any purpose whatever.”799 One question that arises in the context of prepetition equity security holders and the absolute priority rule is whether prepetition equity security holders can purchase equity from, or contribute new value to retain equity in, the reorganized debtor. This potential exception to the absolute priority rule is commonly called the new value exception or corollary.800 The Supreme Court provided some guidance on the new value corollary in Bank of America National Trust and Savings Assn. v. 203 North LaSalle Street Partnership.801 In 203 North LaSalle, the Supreme Court held: “A debtor’s pre-Bankruptcy equity security holders may not, over the objection of a senior class of impaired creditors, contribute new capital and receive ownership interests in the reorganized entity, when that opportunity is given exclusively to the old equity security holders under a plan adopted without consideration of alternatives.”802 Although the Supreme Court acknowledged that the new value 16 corollary might exist under some circumstances,803 it did not resolve the, issue. Lower courts have 1 20 ber 2 ve adopted different approaches to assessing this potential exception. m n No o ived arch 5363 Courts and commentators generally have.interpreted 203 North LaSalle as requiring a “market test” 14-3 No n, before a court confirms a chapter w plan in which prepetition equity security holders retain or . Bro 11 eth v s receive equity in ithe in Blix reorganized entity in violation of the absolute priority rule.804 Courts do not, c ted however, necessarily agree regarding the parameters of this market test or the minimum process required to satisfy the 203 North LaSalle standard. In fact, some courts appear to limit the potential market tests to the two examples identified by the Supreme Court in 203 North LaSalle — i.e., a competing chapter 11 plan or competitive bidding.805 799 N. Pac. Ry. Co. v. Boyd, 228 U.S. 482 (1913). 800 Courts consider several factors in assessing the new value corollary and generally require that the purported new value be (i) new, (ii) substantial, (iii) in money or money’s worth, (iv) necessary for a successful reorganization, and (v) reasonably equivalent to the value of the stock being retained or received. See, e.g., Bonner Mall P’ship v. U.S. Bancorp Mort. Co. (In re Bonner Mall P’ship), 2 F.3d 899, 908 (9th Cir. 1993), cert. granted sub nom. U.S. Bancorp Mortg. Co. v. Bonner Mall P’ship, 510 U.S. 1039 (1994), motion to vacate denied and case dismissed, 513 U.S. 18 (1994). 801 Bank of Am. Nat’l Trust & Sav. Ass’n v. 203 N. LaSalle St. P’ship, 526 U.S. 434 (1999).  802 Id. 803 See id. (“The upshot is that this history does nothing to disparage the possibility apparent in the statutory text, that the absolute priority rule now on the books as subsection (b)(2)(B)(ii) may carry a new value corollary.”). See also Nicholas L. Georgakopoulos, New Value After LaSalle, 20 Bankr. Dev. J. 1, 2 (2003) (observing that the Supreme Court affirmed the new value corollary in LaSalle). 804 See, e.g., In re Castleton Plaza, LP, 707 F.3d 821 (7th Cir. 2013) (rejecting new value plan because lack of market competition prevented court from being able to test purported new value in exchange for grant of 100 percent of reorganized equity to insider in violation of absolute priority rule). See also Robert J. Keach, LaSalle, The “Market Test” and Competing Plans: Still in the Fog, Am. Bankr. Inst. J., Dec. 2002, at 18 (2002). 805 See Bank of Am. Nat’l Trust & Sav. Ass’n v. 203 N. LaSalle St. P’ship, 526 U.S. 434, 458 (1999) (“Whether a market test would require an opportunity to offer competing plans or would be satisfied by a right to bid for the same interest sought by old equity is a question we do not decide here.”). See also In re Situation Mgmt. Sys., 252 B.R. 859, 861, 865 (Bankr. D. Mass. 2000) (rejecting new value plan “was not confirmable in the absence of competitive bidding for the equity interests to determine the adequacy of the new value contribution”). VI. Proposed Recommendations: Exiting the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 232 of 402 Bankruptcy Institute New Value Corollary: Recommendations and Findings The Commissioners discussed the new value corollary and its potential role in facilitating plans of reorganization. Several Commissioners commented on the need to provide some mechanism to allow prepetition equity security holders to retain or receive equity in the reorganized debtor. They noted that this issue was particularly relevant in cases where prepetition equity security holders included founders or other individuals whose continued association with the business was critical or valuable to the reorganized debtor. In this regard, these Commissioners believed that authorizing the new value corollary furthered the underlying reorganization goals of chapter 11. The Commissioners also discussed instances in which prepetition equity security holders were the only, or most viable source, of funding for the chapter 11 plan. Some of the Commissioners observed that, in such cases, the requirements of the new value corollary, including the market test component, should be easily satisfied. Other Commissioners noted, however, that the uncertainty surrounding the application of the new value corollary can make this an expensive and, in some cases, impracticable process. The Commission reviewed the testimony it received on the new value corollary and the impediment it can pose to plan confirmation.806 The Commission determined that chapter 11 reorganizations would benefit from further clarity on the new value corollary. It agreed that codifying the new value corollary as an expressed exception 16 to the absolute priority rule and identifying the key elements of the exception2would enhance the 1, 0 ber 2 confirmation process in many cases. Accordingly, the Commission ovem recommended a statutory new nN ed o value corollary that required (i) new money or money’sarchiv (ii) in an amount proportionate to worth; 63 -353 the equity received or retained by prepetitionoequity security holders; and (iii) that would be subject . 14 ,N rown to a “reasonable” market test. Theth v. B Commission declined to define an appropriate market test; rather, se n Bl it believed that courtsitshouldixmake this determination based on the facts, the evidence presented, i c ed and what would be reasonable in the particular case before the court. 3. Section 506(c) and Charges Against Collateral Recommended Principles: The trustee should not be permitted to waive its ability to surcharge collateral, or to agree not to pursue such a surcharge, to the extent permitted under section 506(c) of the Bankruptcy Code. The surcharge under section 506(c) should continue to apply only to collateral securing prepetition debt and should not apply to new money extended solely on a postpetition basis. 806 See, e.g., Written Statement of Maria Chavez-Ruark: CFRP Field Hearing Before the ABI Comm’n to Study the Reform of Chapter 11, at 2 (Nov. 7, 2012) (discussing inconsistencies in the application of the new value corollary). “The corollary makes sense from a policy standpoint. The underlying policy for a reorganization is rehabilitation of the business, as failed businesses lead to a loss of jobs and loss of capital, both manifestations of economic inefficiency. The new value corollary recognizes that equity holders who inject new capital into a restructured business are not gaining a position ahead of creditors because of their old equity position. Instead, they are taking a concrete step to restore the business to solvency by paying fair value for the reorganized debtor’s stock.” Id.  VI. Proposed Recommendations: Exiting the Case Case: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 233 of 402 ABI Commission to Study the Reform of Chapter  Section 506(c) and Charges Against Collateral: Background Two common questions arise in the context of proceeds from property serving as collateral for a secured creditor: Can those proceeds be used to reimburse the estate for the cost of maintaining and monetizing the property, and can those proceeds be used to pay general administrative or other claims against the estate? The Bankruptcy Code addresses the first question, but it does not speak directly to the second. Section 506(c) of the Bankruptcy Code provides: “The trustee may recover from property securing an allowed secured claim the reasonable, necessary costs and expenses of preserving, or disposing of, such property to the extent of any benefit to the holder of such claim, including the payment of all ad valorem property taxes with respect to the property.”807 This section protects the estate, and it allows the trustee808 to request payment for money expended on, or resources committed to, a secured creditor’s collateral.809 In addition, the trustee must establish that the expenditures were “reasonable” and “necessary” and provided a benefit to the secured creditor. The section protects a secured creditor’s collateral by incentivizing the trustee to preserve that collateral. It also protects the estate by ensuring that the secured creditor pays for this protection.810 Courts have encountered several issues in applying section 506(c), including the scope of expenses included within the section and the identity of parties with standing to request payment under the 16 section. Determining the kind of expenses that may be paid from a secured0creditor’s collateral is a 21, 2 berpreservation of the collateral 811 fact-intensive inquiry. Costs directly related to the maintenance m veand n No 812 ed oto recover certain costs associated with typically are covered. In addition, the trustee may rbeiv ch able 63 a -353 operating the business if those expenditures in turn benefited the secured creditor.813 Whether the . 14 , No own rfees and expenses, however, is less clear. Courts scrutinize such trustee can recover its attorneys’ v. B seth requests closely andin Blix recovery in only very limited circumstances. The Third Circuit has permit cited explained that a debtor in possession’s attorneys’ fees and expenses “may be charged only against the surplus of the debtor’s estate.”814 The trustee’s attorneys’ fees and expenses are only one type of administrative claim that may be incurred pending the sale of a secured creditor’s collateral. As suggested above, whether any particular administrative claim is within the scope of section 506(c) turns on whether the expenditure was 807 11 U.S.C. § 506(c). 808 As previously noted, references to the trustee are intended to include the debtor in possession as applicable under section 1107 of the Bankruptcy Code, and implications for debtors in possession also apply to any chapter 11 trustee appointed in the case. See supra note 76 and accompanying text. See generally Section IV.A.1, The Debtor in Possession Model. 809 “Any time the trustee expends money to provide for the reasonable and necessary cost and expenses of preserving or disposing of a secured creditor’s collateral, the trustee is entitled to recover such expenses from the secured party or from the property securing an allowed secured claim held by such party.” 124 Cong. Rec. H11089 (Sept. 28, 1978), reprinted in 1978 U.S.C.C.A.N. 6436, 6451. 810 See, e.g., Loudoun Leasing Dev. Co. v. Ford Motor Credit Co. (In re K&L Lakeland, Inc.), 128 F.3d 203 (4th Cir. 1997); In re TIC Memphis RI 13, LLC, 498 B.R. 831 (Bankr. W.D. Tenn. 2013). See also Hartford Underwriters Ins. Co. v. Union Planters Bank, N.A., 530 U.S. 1 (2000) (explaining that section 506(c) stems from practices under the Bankruptcy Act and “trac[ing] its origin to early cases establishing an equitable principle that where a court has custody of property, costs of administering and preserving the property are a dominant charge”) (citations omitted). 811 See 4 Collier on Bankruptcy ¶ 506.05[9] (16th ed. 2014). 812 See id. 813 See In re Flagstaff Foodservice Corp., 739 F.2d 73 (2d Cir. 1984). What costs are “reasonable” and “necessary” in the operation of the business again is a fact-specific inquiry. For example, in sale-based cases, under section 506(c), a court may entertain requests for: (i) the costs of plan completion after the sale of the asset (i.e., “burial expenses”); (ii) professional expenses until the sale date; (iii) the tax consequences of any realized gain from the sale; (iv) payment of section 503(b)(9) claims; (v) break-up fees or expenses; and (vi) costs of preserving the going concern of a portion of a business that is sold. 814 In re Towne, Inc., 536 Fed. App’x 265 (3d Cir. 2013). VI. Proposed Recommendations: Exiting the Case  AmericanCase: 14-35363, 11/28/2016, ID: 10211115, DktEntry: 37-2, Page 234 of 402 Bankruptcy Institute reasonable and necessary to preserve or monetize the collateral, and whether it provided some benefit to the secured creditor as a result. The statute clearly allows the trustee to assert a claim under section 506(c) for such expenses, and most courts have held that administrative claimants themselves lack standing to assert such claims.815 In Hartford Underwriters (In re Hen House), the U.S. Supreme Court specifically held that section 506(c) “does not provide an administrative claimant an independent right to use the section to seek payment of its claim.”816 The Court declined to address, however, whether administrative claimants could assert such claims derivatively through the trustee.817 Lower courts are split on this standing issue.818 The payment of general administrative claims and other types of claims not related to the preservation or monetization of the secured creditor’s collateral is not addressed by section 506(c).819 As discussed above, the language of section 506(c) links the use of collateral proceeds to costs associated in some way with that collateral, and courts generally construe the statute narrowly. The statute thus does not cover “carve-outs” from a secured creditor’s collateral to pay other administrative claims or unsecured claims. “As generally used, a carve out is an agreement between a secured lender, on the one hand, and the trustee . . . on the other, providing that a portion of the secured creditor’s collateral may be used to pay administrative expenses.”820 A secured creditor can agree with the trustee to allow certain costs and claims to be paid from the proceeds of the secured creditor’s collateral. Such carve-outs are common in debtor in possession 6 financing facilities and are subject to approval by the court. The trustee er 21, request authority to may 201 b vem pay administrative claims and other claims from a secured creditor’socollateral, but absent satisfying nN ed o hiv the elements of section 506(c) or obtaining the securedrccreditor’s consent, courts generally deny 63 a -353 14 requests for these types of surcharges.821 In,practice, debtor in possession financing facilities suggest No.