In 2012, ABI initiated a comprehensive analysis of chapter 11 business bankruptcy cases and possible reforms. Following a three-year review process, the ABI Commission to Study the Reform of Chapter 11 recently issued its “2012-2014 Final Report and Recommendations.”[1] ABI believed that such a report was appropriate in light of the changes in businesses, capital structures and the global marketplace since enactment of the Bankruptcy Code in 1978. In particular, companies now frequently have substantial secured debt encumbering most, if not all, of their assets; the assets encumbered are more frequently intangible; the capital structures are more complex and heavily leveraged; and the operations and assets of companies are often located outside of the U.S. In addition, the Commission was cognizant of anecdotal evidence that chapter 11 cases had become too expensive.
With a goal of increasing reorganizations and preserving jobs while maximizing the asset values for debtors’ stakeholders, the Commission’s report covered various topics and exceeded 400 pages. Below are the proposals most directly affecting real estate issues, including (1) secured creditors’ rights; (2) § 363 sales; (3) assumption, rejection and related issues; and (4) plan treatment.
Proposals Affecting Secured Creditors’ Rights[2]
The Commission made multiple proposals regarding adequate-protection provisions of the Bankruptcy Code. First, it noted that valuation for adequate-protection purposes should be determined based on the foreclosure value of the collateral property. The proposals limit this valuation to only the purposes of determining adequate protection and not for any other purpose. For instance, a plan valuation is proposed to be a reorganization or sale use of the collateral, depending on the proposed plan. The Commission sought to clarify the ability of an equity cushion in the collateral to provide adequate protection in appropriate cases. The interplay between these two provisions creates an interesting dynamic.
During a weak economy, the secured lender’s collateral value will be significantly depressed and the debtor would benefit from the potential for reduced adequate-protection payments to the secured lender due to the foreclosure valuation. In a rapidly appreciating real estate market, the secured creditor might benefit due to the reduced likelihood of finding as large an equity cushion in a foreclosure valuation, resulting in a greater likelihood of the debtor making adequate-protection payments. If the secured lender loses its adequate protection from the equity cushion, the Commission proposed that the debtor be forced to conduct a § 363 sale of the collateral, unless the secured creditor elects otherwise. The Commission also sought to provide a secured lender with the protection of cross-collateralization of pre-petition debt with post-petition assets, but only to provide adequate protection against a decrease in value of pre-petition, existing collateral.
The Commission proposed that attorneys’ fees asserted in a secured creditor’s proof of claim be explicitly subject to the approval standards of § 330. In addition, if such fees were denied under that provision, the secured creditor is not permitted to seek a disallowed fee from alternative sources. As nearly every mortgage contains a fee-allowance provision for enforcement of the mortgage, the impact could be felt in every case where a secured lender, particularly a first position lender, is oversecured.
Proposals Affecting § 363 Sales[3]
The Commission proposed that § 363 be explicitly revised to provide for an expansive interpretation of the authority to sell property free and clear of claims and interests, essentially allowing sales free of anything, including successor-liability claims, other than property interests or obligations that run with land, successor-liability claims under federal labor laws, or competing or disputed ownership claims. Beyond expanding its scope, the Commission suggested protecting a debtor’s ability to conduct the sale and obtain a breathing spell (while reducing secured lenders’ and debtor-in-possession lenders’ ability to dictate terms) by prohibiting certain benchmarks and milestones within the first 60 days of a case when financing is provided under § 364. Debtors are also prohibited, absent a showing of harm to the property’s value, from conducting a sale within the first 60 days of the case.
The Commission also addressed the § 363 sale process and sought to protect secured creditors by proposing that the right to credit-bid may not be set aside solely because it would chill bidding.
To the extent that a debtor sought to sell substantially all its assets, the Commission recommended a plan-light procedural process, including a notice to all creditors and equityholders, as well as other § 1129 requirements, including the need to generate sufficient funds or set aside proceeds to ensure payment of §§ 507(a)(2)-(3) claims, as well as U.S. Trustee fees. Following a § 363 sale, the Commission opposed the reconsideration of a sale and auction orders absent procedural problems, such as an inadequate notice or improperly conducted auction. Explicitly excluded as a sole grounds for reconsideration of a sale order would be the potential for the sale or realize a greater value. By doing so, the Commission placed the integrity of the bankruptcy auction process as a system over the particular ability of debtors in select cases to seek to supplement the estate by reopening final sale orders.
In a related manner, the Commission also addressed unexpired leases, noting that they could be assumed or rejected in connection with a sale as long as the provisions of § 365 were satisfied. To address § 365, the Commission explicitly suggested the adoption of the Countryman test for executory contracts and reiterated that, in connection with both leases and executory contracts, the debtor need not cure non-monetary defaults that are impossible to cure.
Proposals Affecting Assumption, Rejection and Related Issues[4]
In addition to addressing clarification for leases in connection with § 363 sales, the Commission also expressed desire to see several resolutions regarding treatment of unexpired leases under § 365 and § 502(b)(6). Specifically, the Commission proposed clarifying that rent, for purposes of § 502(b)(6) claims, includes all recurring monetary obligations of the lessee debtor. Further, landlords would have a mandatory mitigation requirement and the § 502(b)(6) claim would be reduced by the amount of security deposits held by the landlord. However, claims for damages to the property caused by the debtor would be explicitly excluded from the § 502(b)(6) cap. Regarding the cap, the Commission proposed that the cap be clarified as the greater of (1) one year reserved and (2) unpaid rents, plus (a) the shorter of 15 percent of rent for the remaining term and (b) three years rent. This clarification is intended to address cases wherein the Commission felt that courts misapplied the existing § 502(b)(6) cap language.
For purposes of § 365(d)(3) claims, the Commission proposed the adoption of the accrual method of calculating rents, but limited any claims under that section to only the monetary obligations of the debtor and payment as an ordinary administrative expense, not superpriority.
Under the Commission’s standard for § 365(d)(3), a nondebtor counterparty to an executory contract or unexpired lease could enforce the debtor’s nonmonetary obligations thereunder if it demonstrated to the court that the harm from nonenforcement to the nondebtor party substantially outweighed the benefit from nonenforcement to the estate. Finally, in furtherance of the Commission’s overall desire to provide debtors with a more complete breathing spell early in the case and increase the likelihood of a reorganization, the Commission recommended extending the time to assume or reject nonresidential real estate leases to one year, from the existing 210 days.
Proposals Affecting Plan Treatment[5]
Some of the Commission’s most expansive proposed changes are those to the plan process and requirements for the debtor, most of which directly impact real estate-related cases as much as operating debtors. Of particular import to single-asset real estate (SARE) cases, the Commission suggested eliminating the requirement that the debtor obtain at least one voting class to move to cram down. In many cases, the secured lender’s deficiency claim might be enough to control all voting classes, or the other classes are so thinly populated that the secured lender may purchase sufficient claims to control all classes. On the opposite side of the spectrum, debtors are incentivized to gerrymander the classes to obtain at least one voting class. The Commission felt that this classification process and incumbent gamesmanship created a waste of resources toward litigation that outweighed the potential benefit of the requirement of one voting class (i.e., that the debtor obtain at least some creditor support for the plan).
Although the lack of a consenting class has received considerable attention, other provisions would also impact real estate-related cases. For example, the Commission explicitly rejected the Till methodology of calculating confirmation cramdown interest rates in favor of a market approach, even when there is no efficient market. In that instance, the Commission believed that courts should nevertheless analyze the risks associated with the plan and what interest rates might be attributed to such risk. The Commission also seeks to codify the new value exception to the absolute priority rule, eliminate class-skipping gifts from senior secured lenders if the gifts violate the absolute priority rule and eliminate the use of structured dismissals following § 363 sales.
Perhaps the most original concept proposed by the Commission is the suggestion of the payment to the first level of junior secured debt that is out of the money (or mostly out of the money) in a distribution scheme to entitlement payment of what is termed the “redemption option value.” While the mechanisms for obtaining or waiving the redemption option value are beyond the scope of this article and the Commission acknowledge that there are several aspects of the analysis that would need to be considered, the basic concept is an attempt to provide such junior creditors with the value of a theoretical option on the potential increase in value, over the amount of senior secured debt, during a three-year period. The option price should be paid from the funds that were otherwise available to the senior secured creditors. The Commission acknowledged that in some instances, the option value might be zero. While these provisions seemingly address concerns with going-concern values in operational reorganizations, the concept is broad enough that it would be a substantial issue of negotiation and perhaps litigation in a real estate case with multiple tranches of secured debt.
For non-SARE debtors with less than $10 million in assets or liabilities that are not publicly traded (a category that represents the vast majority of cases throughout the nation) the Commission proposed the creation of a small or medium enterprise (SME) designation. The key provisions relative to real estate-based cases include the debtor’s ability to, within 60 days of the petition, propose its own subsequent plan-filing deadlines and timelines, although theoretically the exclusivity provisions are still otherwise applicable. It would be interesting to see how often courts would approve a plan deadline beyond the existing exclusivity deadline without also extending that deadline. In an SME case, an unsecured creditors’ committee would only be appointed upon request of the U.S. Trustee or an unsecured creditor, combined with a court finding that it was necessary to protect the interests of unsecured creditors. An undersecured claim in an SME case would be bifurcated, but the secured creditor would not be permitted to exercise rights under §§ 1111(b) or 1129(a)(7)(B).
Lastly, as long as the SME debtor provided unsecured creditors with preferred stock interests in the reorganized debtor on account of unpaid claims, existing equity could retain the common stock in a reorganization as an exception to the absolute priority rule. There are limitations on this proposed right, including the necessity of existing equity’s continued involvement in the management of the debtor to the same extent as prior to filing.
Conclusion
The Final Report’s executive summary begins by noting that 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 in-court or out-of-court resolution of the company’s financial distress.”[6] Consistent with this statement, much of the Commission’s Final Report may be understood as aimed at increasing the use of chapter 11. While some proposals attempt to accomplish this goal by directly changing the substantive law of chapter 11 (e.g., cram down requirement changes), many attempt to do so by reducing uncertainty surrounding existing law (e.g., § 502(b)(6) clarifications). Whether or not ultimately enacted by Congress, these proposals — and their analysis of legislative history, policy and modern-day chapter 11 practice — might be a powerful resource for courts interpreting existing and unsettled provisions affecting real estate.
[1] Learn more about the Commission’s work at commission.abi.org. The Final Report can also be purchased from the Commission’s website.
[2] See Sections IV.(A)(7) and IV.(B)(1) of the Final report.
[3] See Sections IV.(B)(2), IV.(C), V.(A), V.(B), and VI.(B) of the Final report.
[4] See Sections V.(A)(6) of the Final report.
[5] See Sections VI.(C)(1), (2), (5), and (6), VI(F)(1), VI.(G), and VII of the Final report.
[6] See Section II of the Final Report at 6.