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It’s an exciting time to be a bankruptcy lawyer. After a lull of several years, business bankruptcy filings are expected to begin rising later this year. However, the next downturn will differ markedly from its predecessors and will have an impact on filing companies, financial institutions and the bankruptcy bar. Significant changes in the financial markets over the past several years and the recent amendments to the Bankruptcy Code have altered the rules of the game. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) wrought major substantive changes to the sections of the Bankruptcy Code governing business reorganizations. BAPCPA’s major changes include limits on senior management compensation, the exclusive right of a debtor to file a plan of reorganization and the ability of a debtor to assume nonresidential leases. The rights of utility service providers, taxing authorities and general trade creditors, among others, have been strongly enhanced. As a result, so-called “free fall” cases, in which companies utilize Chapter 11 of the Bankruptcy Code primarily for its debtor protections to gain a respite from creditors while developing a reorganization plan, are being significantly affected. BAPCPA’s changes are making stand-alone reorganizations more difficult, particularly for retail or manufacturing enterprises that have large numbers of suppliers and leasehold interests, or for companies facing complex issues, such as environmental liabilities and legacy claims (i.e., pension and retiree benefits) that need to be resolved. Prepackaged and prenegotiated cases centering on new equity investment, debt-for-equity swaps or sales of significant assets are increasing. However, nearly 18 months after BAPCPA’s enactment, the scope, meaning and application of many of its major provisions remain uncertain. This article will examine two of the significant changes effected by BAPCPA-senior management compensation and adequate assurance of payment for utility service providers-together with the manner so far in which debtors and creditors have reacted to such changes, and how courts have ruled on such efforts. While the purported intent of the BAPCPA amendments was to remove some degree of control from debtors’ management, many of BAPCPA’s key provisions were not clearly drafted, and the recent relative dearth of filings of cases under Chapter 11 of the Bankruptcy Code means that these changes have barely begun to be interpreted by courts. Accordingly, even as the process of business reorganizations under Chapter 11 is undergoing a dramatic change, the full extent of such change will be difficult to gauge fully until business bankruptcy filings begin to return to historical norms. If it’s true, as is said, that an army travels on its stomach, then perhaps the applicable corollary for a corporation is its executive compensation programs. Probably more than any other provisions in the BAPCPA amendments, the limitations on key employee retention and severance plans were clearly aimed at diminishing the power of a debtor’s management. Standards before BAPCPA Prior to BAPCPA, there were no Bankruptcy Code provisions directly addressing senior management and key employee compensation programs. Such programs were subject to the same standards under � 363(b) of the Bankruptcy Code and reviewed in the same manner as most other activities undertaken by a debtor under Chapter 11 that fell outside of “the ordinary course of business.” Key employee retention programs (KERPs) were generally approved so long as they could be shown to be a proper exercise of a debtor’s business judgment, and in line with a debtor’s historical compensation practices and general industry standards. See, e.g., In re Montgomery Ward Holding Corp., 242 B.R. 147 (D. Del. 1999); In re America West Airlines Inc., 171 B.R. 674 (Bankr. D. Ariz. 1994). Although the particular amounts of a KERP were often contested, the underlying rationale-the debtor’s need to retain experienced management to guide it through the reorganization process-usually was not. The negotiations and implementation of a KERP became part of most Chapter 11 cases of any major size. Evidently as a response to the perception fueled by Enron, WorldCom and other major cases from the early part of this decade that a debtor’s senior managers were not sharing enough of the pain felt by creditors and rank-and-file employees arising from a corporate bankruptcy, BAPCPA added a new subsection (c) to � 503 of the Bankruptcy Code, setting forth new, difficult standards for the approval of a retention or severance plan for an officer or director of a debtor “for the purpose of inducing such person to remain with the debtor’s business[.]“ Under subsection (c)(1), payments designed to induce an officer or director of a debtor to remain with the business are prohibited unless the bankruptcy court finds that: “(A) [the payment] is essential to retention of [such] person [because of a bona fide competing job offer] at the same or greater rate of compensation; (B) the services [such person] are essential to the survival of the business; and (C) either-(i) the amount [of the payment] is not greater than . . . 10 times . . . the mean transfer or obligation of a similar kind given to nonmanagement employees for any purpose during the prior calendar year . . . ; or (ii) if no such [payments] were made . . . , [the amount of the payment is not greater than] 25 percent of the amount of any similar transfer or obligation” made or incurred during the prior calendar year. Under subsection (c)(2), no severance payments to an insider are permitted unless the payment is part of a program generally applicable to all full-time employees, and the amount of payment is not greater than 10 times the amount of the mean severance payment given to nonmanagement employees during the prior calendar year. Incentive payment exceptions However, new subsection (c)(3) of � 503, which provides a catchall prohibition on “other transfers or obligations [to officers or managers] not justified by the facts and circumstances of the case,” has provided a basis for debtors to continue to propose, and for courts to approve, new compensation programs for senior managers. Rather than seeking to satisfy the heavy burden imposed for retention and severance payments under � 503(c)(1) and (2), debtor companies have instead sought approval for “incentive” programs, arguing that such programs are indeed justified by the facts of the case. While many creditors and the U.S. trustees have objected that such a change in nomenclature effects an impermissible “end run” around the intent of the BAPCPA provisions regarding senior management compensation, the trend of courts so far, at least in the District of Delaware and the Southern District of New York, has been to accept the distinction between “retention” and “severance,” on the one hand, and “incentive,” on the other, and to approve the latter such programs. See, e.g., In re Nobex Corp., No. 05-20050 (Bankr. D. Del. Jan. 12, 2006); In re Pliant Corp., No. 06-10001 (Bankr. D. Del. March 14, 2006). ‘In re Dana Corp.’ example The decisions of Judge Burton R. Lifland in In re Dana Corp., No. 06-10354 (Bankr. S.D.N.Y. Sept. 4, 2006 ( Dana I) and Nov. 30, 2006 ( Dana II)), regarding Dana’s proposed senior manager compensation programs, provides perhaps the clearest indication yet of the distinctions courts may be willing to make between retention payments that the BAPCPA amendments have virtually prohibited, and incentive payments that evidently remain permissible. Lifland initially denied a proposed compensation program for the debtor’s chief executive officer and senior officers that included a $6.2 million “completion bonus.” The court noted that the bonus was not tied to achieving any significant performance benchmarks other than the emergence of Dana Corp. and its subsidiaries from Chapter 11: “Without tying this portion of the bonus to anything other than staying with the company until the Effective Date, this Court cannot categorize a bonus of this size and form as an incentive bonus. Using a familiar fowl analogy, this compensation scheme walks, talks and is a retention bonus.” Dana I, slip op. at 12. Dana subsequently sought approval for a revised compensation program. The court found that the revised program “requires that the company reach certain [financial performance] benchmarks before the CEO and Senior Executives will be eligible for any payment under the long-term incentive plan. This . . . is a significant change from the terms of the doomed Initial Compensation Motion, where Debtors’ sought approval . . . [for] a bonus being awarded even if the total enterprise value of the company declined by the time the company emerged.” Dana II, slip op. at 23. The court concluded, “By presenting an executive compensation package that properly incentivizes the CEO and Senior Executives to produce and increase the value of the estate, the Debtors have established that Section 503(c)(1) does not apply to the Executive Compensation Motion.” Id. at 28. Lifland approved the proposed compensation as an appropriate incentive program under � 503(c)(3). Utility service providers BAPCPA amended � 366 of the Bankruptcy Code, altering the rights available to a utility service provider when a customer files for bankruptcy protection. One clear effect has been to increase the cash needs of companies that seek protection under Chapter 11. As a result, as with senior management compensation, many debtors have sought ways to mitigate or even fully work around the dictates of the new statutory language. Prior to BAPCPA, under subsection (a) of � 366, a utility company could not “refuse, or discontinue service to,” a company in Chapter 11 because of debts owed prior to the commencement of the case. Under subsection (b) of old � 366, service could only be discontinued if, within 20 days after the filing date, the utility company did not receive “adequate assurance of payment” for service after such date. However, utility companies had very little leverage to require a cash deposit or equivalent form of security. Courts would often rule that no deposit was required because the debtor had a steady payment history, and would determine that an allowed administrative claim (i.e., a heightened priority of payment among unsecured creditors) for any post-petition payments due on account of such services constituted adequate assurance of payment. The BAPCPA amendments changed � 366 by explicitly defining “adequate assurance of payment” under new � 366(c)(1)(A) to mean a cash deposit; a letter of credit; a certificate of deposit; a surety bond; prepayment of utility consumption; or another form of security mutually agreed upon between the debtor or trustee and the utility service provider. Under new � 366(c)(1)(B), a bankruptcy court can no longer order that an administrative expense priority claim constitutes adequate assurance of payment. Furthermore, new � 366(c)(2) provides that a utility company can now alter, refuse or discontinue utility service altogether if it does not receive, during the 30-day period following the petition date, “adequate assurance of payment . . . that is satisfactory to the utility.” However, revised � 366 is not self-executing, and Chapter 11 debtors appear to be taking advantage of the fact that some utility companies may not be able to act quickly during the early stages of a debtor’s case. Debtor companies seeking relief under Chapter 11 have in several cases filed a “first day” motion requesting an order from the bankruptcy court expressly placing the burden on a utility service provider to request a security deposit, and to object to the proposed form and amount of the security deposit or other assurance of payment within a specific period of time (usually within 20 to 30 days). Typically under these orders, a failure to respond results in a deemed acceptance of the debtor’s proposal and a waiver of the right to terminate service without further court order. Accordingly, notwithstanding the new statutory language of � 366, some courts are permitting debtors to shift the burden back onto utility companies both to request a security deposit, and to show that a debtor’s proposed form of security is not adequate. See, e.g., In re Easy Gardener Products Ltd., No. 06-10396 (Bankr. D. Del. May 15, 2006); In re ProSoft Learning Corp., No. 06-01008 (Bankr. D. Ariz. April 13, 2006); In re Curative Health Services Inc., No. 06-10552 (Bankr. S.D.N.Y. April 18, 2006). Placing onus on the debtor In contrast, at least one court has gone to the other extreme, and determined that the utility company has the sole discretion to accept the proposed “adequate assurance of payment,” and that, if the utility company did not accept the debtor’s offer, the court had no power to extend the injunction imposed by � 366(c) beyond the 30-day period. See In re Lucre, 333 B.R. 151 (W.D. Mich. 2005). In that case, the debtor filed a motion and sought to impose its offer of adequate assurance on utility companies that failed to respond to its offer. The court, however, reading the language of new � 366(c)(2) literally, held that even if a utility company did not respond, the injunction would be lifted and the utility company would be free to alter the debtor’s utility service. See id. at 154. The court stated that � 366(c)(2) squarely placed the onus upon the debtor to reach an agreement regarding the debtor’s offer of adequate assurance of payment that was satisfactory to the utility company. While acknowledging that “[a]t first blush, such an effort would appear to be a fool’s errand[,]” the court suggested, without deciding, that the exercise by a utility company of its sole discretion to accept adequate assurance of payment under subsection (c)(2) contained an implied obligation to negotiate in good faith. Id. Even as restructuring professionals scan the horizon for signs of tightening in the unprecedented flow of liquidity that has fed the current lending boom and caused default rates to drop to all-time low levels, there is little consensus right now on how the substantive changes of BAPCPA will ultimately be interpreted by the courts. The next major wave of cases is coming, but until it does, and BAPCPA’s provisions become clearer through litigation and appellate court review, the impacts of these developments are going to remain uncertain. The court battles over the meaning and application of these new provisions promise to be hard fought. Benjamin D. Feder is a partner in the bankruptcy, commercial and public finance and corporate transactions and securities practice groups in the New York office of Thompson Hine. He can be reached at [email protected].

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