General Issues in Chapter 11

GENERAL ISSUES IN CHAPTER 11

The Chapter 11 Working Group investigated issues that arise in general business cases. The Working Group engaged in a continuous process of canvassing secured creditor representatives, a variety of unsecured creditors representatives, debtors' representatives, businesspeople, investment analysts, economists, legal scholars, judges, trustees, and any other interested parties. The issues derived through that process were then developed throughout the Commission's deliberations. The Recommendations set forth by the Chapter 11 Working Group and adopted by the Commission are aimed at enhancing the return and lowering the costs for many different types of creditors while embracing the basic goal in Chapter 11 to promote reorganizations.

Many of the following Recommendations would resolve open legal questions that frequently cause litigation and delay. Clarification will minimize the time and money lost to repeated judicial disputes over issues such as the rules governing classification of claims, court review of creditors' committee appointments, and the permissibility of releasing claims against nondebtor parties. Because bankruptcy laws provide a backdrop for a broad range of out of court negotiations, increased certainty enhances the opportunities for out of court workouts.

The Working Group also developed recommendations that affirmatively would promote speed and efficiency within the current reorganization structure. Some recommendations, such as those to facilitate prepackaged bankruptcies and to authorize local mediation programs, should further these goals directly. Others promote those values indirectly, such as the Recommendation to promote sales of assets in Chapter 11 cases.

To maintain the balance in the business bankruptcy system, it also is important to consider whether the costs of business bankruptcy are borne disproportionately by certain groups. While discussions of bankruptcy often are polarized into "debtor" versus "creditor" debates, a more delicate balance must be struck among the members of the diverse creditor body. Whether the debtor seeks to reorganize or liquidate, the Bankruptcy Code must reconcile competing needs of secured lenders, unsecured lenders, trade suppliers, employees, utility providers, independent contractors, lessors, lessees, other contract creditors, taxing authorities, warranty holders, tort victims, and infinite other types of claimants. Although the priority of payment is relatively clear in the statute, a wide variety of other questions can have significant distributional implications. Instead of addressing this concern with a series of amendments directed at discrete groups of creditors to the exclusion of others, the Chapter 11 Working Group, as well as other working groups, attempted to make moderate adjustments to the current system to enhance the system's fairness.

Recommendations

2.4.1 Clarifying the Meaning of "Rejection"

The concept of "rejection" in section 365 should be replaced with "election to breach."

Section 365 should provide that a trustee's ability to elect to breach a contract of the debtor is not an avoiding power.

Section 502(g) should be amended to provide that a claim arising from the election to breach shall be allowed or disallowed the same as if such claim had arisen before the date of the filing of the petition.

2.4.2 Clarifying the Option of "Assumption"

"Assumption" should be replaced with "election to perform" in section 365.

2.4.3 Interim Protection and Obligations of Nondebtor Parties

A court should be authorized to grant an order governing temporary performance and/or providing protection of the interests of the nondebtor party until the court approves a decision to perform or breach a contract.

Section 503(b) should include as an administrative expense losses reasonably and unavoidably sustained by a nondebtor party to a contract, a standard based on nonbankruptcy contract principles, pending court approval of an election to perform or breach a contract if such nondebtor party was acting in accordance with a court order governing temporary performance.

2.4.4 Contracts Subject to Section 365; Eliminating the "Executory" Requirement

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.

2.4.5 Prebankruptcy Waivers of Bankruptcy Code Provisions

Section 558 of the Bankruptcy Code should provide that except as otherwise provided in title 11, a clause in a contract or lease or a provision in a court order or plan of reorganization executed or issued prior to the commencement of a bankruptcy case does not waive, terminate, restrict, condition, or otherwise modify any rights or defenses provided by title 11. Any issue actually litigated or any issue resolved by consensual agreement between the debtor and a governmental unit in its police or regulatory capacity, whether embodied in a judgment, administrative order or settlement agreement, would be given preclusive effect.

2.4.6 Prepackaged Plans of Reorganization; Section 341 Meeting of Creditors

Section 341 should provide that upon the motion of any party in interest in a Chapter 11 case that entails a prepackaged plan of reorganization, the court may waive the requirement that the U.S. trustee convene a meeting of creditors.

2.4.7 Authorization for Local Mediation Programs

Congress should authorize judicial districts to enact local rules establishing mediation programs in which the court may order non-binding, confidential mediation upon its own motion or upon the motion of any party in interest. The court should be able to order mediation in an adversary proceeding, contested matter, or otherwise in a bankruptcy case, except that the court may not order mediation of a dispute arising in connection with the retention or payment of professionals or in connection with a motion for contempt, sanctions, or other judicial disciplinary matters. The court should have explicit statutory authority to approve the payment of persons performing mediation functions pursuant to the local rules of that district's mediation program who satisfy the training requirements or standards set by the local rules of that district. The statute should provide further that the details of such mediation programs that are not provided herein may be determined by local rule.

2.4.8 Court Review of Appointments to Creditors' Committees

Subsection (a)(2) of 11 U.S.C. § 1102, "Creditors' and equity security holders' committees," should be amended to read as follows:

(2) On request of a party in interest and after notice and a hearing, the court may order a change in membership of a committee appointed under subsection (a) of this section if necessary to ensure adequate representation of creditors or of equity security holders. On request of a party in interest, the court may order the appointment of additional committees of creditors or of equity security holders if necessary to assure adequate representation of creditors or of equity security holders. The United States Trustee shall appoint any such committee.

2.4.9 Employee Participation in Bankruptcy Cases

Changes to the Official Forms, the U.S. Trustee program guidelines and the Federal Rules of Bankruptcy Procedure, are recommended to the Administrative Office of the U.S. Courts, the Executive Office of the U.S. Trustee, and the Advisory Committee on Bankruptcy Rules of the Judicial Conference, as appropriate, in order to improve identification of employment-related obligations and facilitate the participation by employee representatives in bankruptcy cases. The Official Forms for the bankruptcy petition, list of largest creditors, and/or schedules of liabilities should solicit more specific information regarding employee obligations. The U.S. Trustee program guidelines for the formation of creditors' committees should be amended to provide better guidance regarding employee and benefit fund claims. The appointment of employee creditors' committees should be encouraged in appropriate circumstances as a mechanism to resolve claims and other matters affecting the employees in a Chapter 11 case.

2.4.10 Enhancing the Efficacy of Examiners and Limiting the Grounds for Appointment of Examiners in Chapter 11 Cases

Congress should amend section 327 to provide for the retention of professionals by examiners for cause under the same standards that govern the retention of other professionals.

The Advisory Committee on Bankruptcy Rules of the Judicial Conference should consider a recommendation that Federal Rule of Bankruptcy Procedure 2004(a) be amended to provide that "On motion of any party in interest or of an examiner appointed under section 1104 of title 11, the court may order the examination of any entity."

Congress should eliminate section 1104(c)(2), which requires the court to order appointment of an examiner upon the request of a party in interest 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.

2.4.11 Valuation

A creditor's secured claim in personal property should be determined by the property's wholesale price.

A creditor's secured claim in real property should be determined by the property's fair market value, minus hypothetical costs of sale.

2.4.12 Clarifying The Conditions for Sales Free & Clear Under 11 U.S.C. § 363(f)

Congress should make clear that bankruptcy courts can authorize sales of property of the estate free of creditors' interests regardless of the relationship between the face amount of any liens and the value of the property sold.

2.4.13 Release of Claims Against Nondebtor Parties

Congress should amend sections 1123 and 524(e) to clarify that it is within the discretion of the court to allow a plan proponent to solicit releases of nondebtor liabilities. Creditors that agree in a separate document to release nondebtor parties will be bound by such releases, whereas creditors that decline to release their claims against nondebtor parties will not be bound to release their claims.

2.4.14 Exclusion of Payroll Deductions from Property of the Estate

Congress should amend 11 U.S.C. § 541(b) to clarify that funds deducted from paid wages within 180 days prior to the date of the commencement of a case under title 11, held by a debtor/employer, and owed by employees to third parties, other than a federal, state or local taxing authority, do not fall within the definition of "property of the estate."

2.4.15 Absolute Priority and Exclusivity

11 U.S.C. § 1129(b)(2)(B)(ii) should be amended to provide that the court may find a plan to be fair and equitable that provides for members of a junior class of claims or interests to purchase new interests in the reorganized debtor.

11 U.S.C. § 1121 should be amended to provide that on the request of a party in interest, the court will terminate exclusivity if a debtor moves to confirm a non-consensual plan that provides for the participation of a holder of a junior claim or interest under 1129(b)(2)(B) but does not satisfy the condition set forth in section 1129(b)(2)(B)(i).

2.4.16 Classification of Claims

Section 1122 should be amended to provide that a plan proponent may classify legally similar claims separately if, upon objection, the proponent can demonstrate that the classification is supported by a "rational business justification."

2.4.17 Prepetition Solicitation for a Prepackaged Plan of Reorganization

The standards and requirements provided in the Bankruptcy Code for postpetition solicitation should be applicable to solicitation for a plan of reorganization within 120 days prior to filing a Chapter 11 petition by an entity that is subject to and in compliance with the public periodic reporting requirements of the Securities Exchange Act of 1934. Notice of such prepetition solicitation should be served on the Securities and Exchange Commission. If an entity solicits for a plan of reorganization but does not file for bankruptcy, the bankruptcy requirements and standards should be applicable if the entity does not complete an exchange offer or any other transaction on the basis of such solicitation.

2.4.18 Postpetition Solicitation for a Prepackaged Plan of Reorganization

Section 1125(b) should be amended to provide that the acceptance or rejection of a plan may be solicited after the commencement of a case under title 11 but before the court approves a written disclosure statement from those classes that were solicited for the plan prior to the filing of the bankruptcy petition.

2.4.19 Elimination of Prohibition on Nonvoting Equity Securities

Congress should amend section 1123(a)(6) to eliminate the requirement that the charter of the reorganized corporate debtor prohibit the issuance of nonvoting equity securities. Section 1123(a)(6) should otherwise remain unchanged.

2.4.20 Postconfirmation Plan Modification

11 U.S.C. § 1127(b) should be amended to permit modification after confirmation of a plan until the later of 1) substantial consummation or 2) two years after the date on which the order of confirmation is entered. All other restrictions on postconfirmation plan modification in section 1127(b) should remain unaltered.

Discussion

I. Issues Arising During a Chapter 11 Case

Section 365

The filing of a bankruptcy petition triggers the creation of an estate encompassing all of the debtor's property interests, including contractual rights. Unlike many other types of property that come into the estate, contracts involve both rights and duties. Therefore, the treatment of contracts in bankruptcy raises more complicated questions. Whether a contract will enhance or diminish the value of the estate entails an analysis similar to that undertaken by any contracting party outside of bankruptcy. Yet, any such decisions made by a debtor in possession or trustee, both of whom act as fiduciaries to the bankruptcy estate, must be closely monitored by creditors and the court. Section 365, which establishes the rules for this procedure, is, therefore, a critically important provision that should provide clear guidance for the fair and uniform treatment of these obligations. The need for guidance is particularly crucial given the fact that almost every debtor in the bankruptcy system is a party to numerous contracts and leases.

The countless types of contracts and number of circumstances have complicated attainment of the goal of establishing clear and uniform rules. In an attempt to address discrete situations, section 365 has been amended repeatedly over the past twenty years and now spans over thirteen pages in a typical version of the Bankruptcy Code. These additions to section 365 may have abrogated questionable case law interpretations, and have offered pockets of certainty for some industries or types of contracts, but they have not resolved fundamental ambiguities that should be addressed generically.⁽¹¹¹³⁾ Therefore, instead of undertaking a piecemeal analysis of each subsection of section 365, the Commission reviewed the larger conceptual issues inherent in section 365 to eliminate confusion on a more global basis.

2.4.1 Clarifying the Meaning of "Rejection"

The concept of "rejection" in Section 365 should be replaced with "election to breach."

Section 365 should provide that a trustee's ability to elect to breach a contract of the debtor is not an avoiding power.

Section 365 permits a debtor in possession or trustee to elect to "reject" a contract entered prepetition, subject to court approval. The term "rejection" has no obvious state contract law counterpart. Although the Bankruptcy Code provides that rejection should be treated as a breach,⁽¹¹¹⁴⁾ the Code does not state expressly that rejection is synonymous with breach, nor does it fully delineate the consequences of a trustee's decision to reject. Not surprisingly, the concept of rejection has been applied inconsistently by the courts, and has led to the numerous special interest amendments to section 365.

The Commission recommends a common-sense clarification of the term "rejection" by replacing it with "election to breach." The Commission further recommends that the Bankruptcy Code delineate the consequences of electing to breach to correct on a generic basis the contrary results reached by some courts.⁽¹¹¹⁵⁾ The bankruptcy trustee's election not to perform a contract is nothing more or less than a breach of the contract and should be treated accordingly.⁽¹¹¹⁶⁾ Rejection does not "nullify," "rescind," or "vaporize" the contract or terminate the rights of the parties; it does not serve as an avoiding power separate and apart from the express avoiding powers already provided in the Bankruptcy Code.⁽¹¹¹⁷⁾ For example, if a debtor entered a contract prepetition and conferred rights in an asset to a nondebtor party, a trustee would not be entitled to repudiate the transfer and retrieve the property unless one of the other avoiding powers--not section 365--permitted it to do so. Under most circumstances, this means that the nondebtor party would be entitled to a claim for money damages, and the contract obligations themselves would be discharged.⁽¹¹¹⁸⁾ The claim would be paid in the bankruptcy pro rata with other unsecured creditors.

With a few important exceptions, bankruptcy law accepts the nonbankruptcy substantive law applicable to a contract,⁽¹¹¹⁹⁾ but bankruptcy adjusts the form of the remedies available upon breach. Damages may be calculated under state law, but they are paid out according to bankruptcy priorities and principles. Specific performance may be available under state law, but it is rarely permitted against the trustee. Thus, state contract law generally defines a party's rights, while federal bankruptcy law determines how those rights are enforced in a bankruptcy case. The most important example, which is the choice between damages and specific performance, has powerful distributional consequences and must be governed by a uniform policy in a bankruptcy case;⁽¹¹²⁰⁾ otherwise, state laws providing very broad rights to specific performance would have the inequitable effect of granting preferential treatment to certain contract creditors, to the detriment of all other general unsecured creditors in bankruptcy.⁽¹¹²¹⁾

The recommended clarifications should prevent the contrary results reached by some courts without requiring enactment of additional special interest legislation in response to each individual case. It would make it clear that the impact of electing to breach under section 365 is limited to the consequences of breach under state law, subject to the limitations on remedies imposed by the Code.

Competing Considerations. Some would argue that a trustee or debtor in possession should be able to avoid or rescind a contract in bankruptcy whenever it would be helpful to a reorganization to do so.⁽¹¹²²⁾ For example, if the debtor is a lessor of copy machines, avoidance of all leases might permit the debtor in possession to sell the machines in bulk, rather than selling only lease residuals. However, this would enable the debtor in bankruptcy to make contracts disappear--a power that is very different from a simple breach of contract for which the debtor would incur damages. If a debtor were empowered to demand possession of property from a third party, the bankruptcy process would readjust the bargains struck at state law, rather than simply determine a claim for breach. To permit the trustee or debtor in possession to undo valid contracts whenever the estate might benefit would introduce a great deal of uncertainty into private bargaining and might lead to abuse.

There is some concern that adjusting the lexicon of section 365 could encourage additional litigation. However, using the word "breach" incorporates a term from state law contract principles with which courts already are familiar. It is likely to diminish rather than increase confusion. Rejection, a concept with no state law contract analogue, has been problematic. The special interest amendments to section 365 reflect an attempt to work around the notion of a breach as a repudiation or avoidance power, consistent with this Proposal. The proposed change is intended to harmonize both the term used and the concept involved in determining what a trustee may do if a contract is not to be performed.

Finally, this Proposal might be criticized as being inadequately remedial since it stops short of dismantling the special interest provisions presently in section 365. Some might take issue with the more conservative approach used by the Commission on the basis that section 365 will remain too complicated even with these changes. More importantly, the proposed changes call into question the interpretation of the complicated, industry-specific provisions that remain in section 365. By negative implication, legislation devoted to only one type of contract undercuts the general applicability of the principles it expresses. Establishing a general rule that is consistent with the principles of the special interest legislation without eliminating the special interest legislation may cause courts to place a more limited interpretation on either the general or the limited rule. It is Congress' prerogative to consider whether this package of amendments vitiates the need for several of the subsections of section 365 that apply only to one type of industry or contract.

2.4.2 Clarifying the Option of "Assumption"

"Assumption" should be replaced with "election to perform" in Section 365.

Court approval of a trustee's request to assume a contract is a significant event. Once a debtor in possession or trustee has assumed a contract, the bankruptcy estate becomes obligated to perform or to find an adequate replacement to perform through its right to assign. Any failure to do so will result in an administrative priority claim for damages that must be paid ahead of all other general creditors,⁽¹¹²³⁾ as opposed to the pro rata distribution that is received by a party to a breached contract. This would be the case whenever a contract is assumed, even if the case later is converted to a Chapter 7 liquidation.⁽¹¹²⁴⁾ The trustee should elect to commit the estate to perform and receive performance or transfer the contract only if such actions are likely to yield a net benefit to the estate, i.e., the value of the nondebtor party's remaining performance exceeds the estate's costs of taking over the debtor's remaining obligations.⁽¹¹²⁵⁾

Due to the confusion already inherent in section 365, the Commission believes that it is sensible to use more comprehensible terms that characterize the events they represent. By using the words "election to perform," this Proposal would introduce a concept parallel to "election to breach" and would replace problematic language with clear language. The Proposal would not change any of the implications of making this election, such as the obligation to cure and give adequate assurance of future performance under section 365(b) and the administrative priority of any prepetition or postpetition claim under the contract.

This Proposal replaces the term "assumption" with "election to perform" to clarify the meaning of the action at issue, but the Commission does not address the severability of contracts to be performed, nor does it address issues arising when a partner files for bankruptcy and the treatment of a partnership agreement, a subject discussed elsewhere in this report.⁽¹¹²⁶⁾ This Proposal also would not alter the economic considerations preceding a trustee's election to perform or assign ("transfer").⁽¹¹²⁷⁾ However the phrase "election to perform" is more consistent with the result intended, but not clearly expressed in section 365(c)(1),⁽¹¹²⁸⁾ that a debtor in possession stand in the shoes of a debtor and is therefore entitled to assume any prepetition contract absent some unusual public policy bar.⁽¹¹²⁹⁾

Competing Considerations. Once again, some might be concerned that any change in terminology will promote litigation. However, "election to perform" is a more apt analogue to "election to breach," and would provide a sensible parallel structure to section 365. The change also helps to develop the distinction between assumption by the estate and assignment to third parties, which involve different legal and policy considerations.

The election to perform and to receive performance under a personal property lease in consumer cases has caused confusion and raises special problems that are not addressed in this Proposal. Trustees may be reluctant to elect to perform these types of leases if they are concerned about taking on personal responsibility for the performance of the leases.

2.4.3 Interim Protection and Obligations of Nondebtor Parties

The value of a contract to the bankruptcy estate and the ability of the debtor to perform the obligation often are unclear at the outset of a bankruptcy case. Even if the debtor files for bankruptcy with the express intent to reorganize, the likelihood of maintaining operations and proceeding to a successful reorganization may not be immediately apparent. In the first chaotic moments after filing, it is generally imprudent for the debtor in possession or trustee to make binding decisions to elect to perform or breach a contract or lease before parties can assess the direction of a case. Because a binding election to perform a contract makes the contractual obligation rise to the level of administrative expense priority and thus significantly affects distributions to all creditors, if the case is converted to Chapter 7 to be liquidated, a contract that the trustee has elected to perform can consume a substantial portion of the estate's assets. The contract creditor will receive a substantial preference, but there may be very little remaining for pro rata distribution to other unsecured creditors.⁽¹¹³⁰⁾ Equally harmful to the estate is a precipitous election to breach a contract that might have been quite lucrative.

For these reasons, the Code does not require immediate elections to breach or performance of outstanding contracts.⁽¹¹³¹⁾ Although nondebtor parties can request that the debtor in possession or trustee make the election early in the case,⁽¹¹³²⁾ courts are reluctant to force early decisions when the economic consequences of such decisions are not clear, even when a debtor indicates an intent to make the election.⁽¹¹³³⁾ Rather, many courts prefer to defer such final decisions to plan confirmation or liquidation.

Policy supports the deferral until the parties can assess and determine the best economic action in light of the circumstances. However, deferral has a potentially costly impact on the nondebtor party to the contract, which raises three questions: 1) Is the nondebtor party expected to prepare or continue to perform pending this election? 2) If so, will the nondebtor party be compensated for his performance? 3) How should the court determine the appropriate measure of damages? These questions should be answered in a way that increases the likelihood that decisions on contracts are not made prematurely and provides that the costs of delaying the decision will be borne by the estate and not by the nondebtor contract party.

Compelling Performance of the Nondebtor. Nothing in current bankruptcy law excuses the nondebtor party to a contract or lease from its performance obligations under the contract or lease during the "gap period" in which the debtor decides whether to breach, perform, or transfer.⁽¹¹³⁴⁾ The Commission's Proposal would recognize explicitly that a court could order the nondebtor party to perform temporarily or prepare to perform according to the contract. Chapter 11 debtors that intend to remain in operation must be able to rely on the return performance of a nondebtor party in order to remain a going concern. If a trustee is going to sell either valuable assets or sell a Chapter 7 debtor as a going concern, a temporary performance order may be equally necessary. However, as discussed below, nothing in current bankruptcy law clearly protects the nondebtor party's right to compensation for such postbankruptcy performance.

Requirement of Compensation. The Commission recommends that the Bankruptcy Code provide express authorization for the payment of nondebtor parties that perform in accordance with temporary performance orders. The Bankruptcy Code presently does not speak directly to the issue of payment to nondebtor parties for their contractual performance, which puts parties in economic peril when they are required to perform.⁽¹¹³⁵⁾ Section 365 requires debtor-lessees to perform on certain leases pending assumption or rejection, but even those provisions have not guaranteed full protection for nondebtor lessors due to the time constrictions and the lack of guidance on method of calculating compensation.⁽¹¹³⁶⁾ Sometimes courts permit a nondebtor party to receive full contract payments in the interim period, only to subject those payments to later scrutiny that may result in disgorgement.⁽¹¹³⁷⁾ Due to the uncertain state of the law, nondebtor parties are more likely to request the court to compel the trustee or the debtor in possession to elect contract performance within a shorter period of time even if the case is not sufficiently mature to assess the effects of this decision on the estate. The Commission's Proposal would give the courts the much-needed general authorization to order payments or to develop other means to ensure that the interests of the nondebtor party to a contract are not further injured or prejudiced pending the trustee's or debtor's election and provide that compensation to the nondebtor party would be entitled to administrative expense priority.

Appropriate Measure of Damages for Postpetition Performance. Because courts have varied greatly in their approaches to determining compensation in this context, this Recommendation would be incomplete without providing additional guidance on the measure of damages. Assessing appropriate compensation and the priority of that compensation can be difficult. Proper compensation should be determined under ordinary contract principles. Whatever compensation would be awarded to the nondebtor party under similar nonbankruptcy circumstances should be its allowed administrative claim for postpetition performance or breach. The courts mistakenly have applied a special bankruptcy rule for this purpose, focusing on the actual and necessary benefit to the estate, but there is no justification for ignoring ordinary contract principles to award compensation for performance or injury from performance that the estate has sought and the court has approved, whether the contract has been assumed or only ordered temporary performance. Part of the confusion arises from the general administrative expense authorization under section 507(a)(1), which uses a standard based on actual benefit to the estate.⁽¹¹³⁸⁾ Without alternative statutory authorization for this type of situation, the courts cannot use appropriate contract principles to determine rightful compensation to the nondebtor party, and therefore sometimes reach an inappropriate result.

The Commission's Proposal would fill this gap. Compensation is designed to be remedial and to minimize the adverse consequences of a delay in the decision to breach or perform. The Proposal therefore focuses squarely on "losses reasonably and unavoidably sustained by a nondebtor party." The nondebtor party's injury is the relevant factor to determine an accurate calculation of damages. The role of the contract price in determining the nondebtor party's remedy will depend on the facts of the case, just as in any nonbankruptcy contract damage action that uses restitution or rescission. The actual injuries suffered by a nondebtor party may be affected by a variety of factors such as when the estate must begin to perform. Some examples illustrate this principle:

A debtor has an equipment lease with equal monthly lease payments. In this instance, the monthly lease payment probably would be the best evidence of the damages of a lessor waiting for the debtor/lessee to elect to breach or perform. Therefore, nonbankruptcy contract principles support using the contract price to determine damages in this context.

A whiskey barrel manufacturer contracts prepetition to deliver whiskey barrels to the debtor one year after the bankruptcy filing. Because these barrels must age, the manufacturer must purchase supplies and begin construction a year in advance of delivery--after the filing but before the debtor has elected to perform or breach. If the nondebtor manufacturer's compensation under an interim performance order were determined only by some fraction of the contract price, the manufacturer would be inadequately compensated. However, under contract restitution principles, the manufacturer would be entitled to significant damages for costs incurred while preparing to perform the contract pending a decision to perform or breach.

Consider the same whiskey barrel manufacturer if the debtor filed for bankruptcy six months later, so that the interim period during which the estate was not bound to perform or to breach occurred after the initial expenses had been incurred prepetition and the barrels were simply aging in a warehouse. In such a case, the manufacturer did not reasonably and unavoidably sustain any losses as a result of the delay, and under an interim performance order it would receive no compensation. Once again, the principle of compensation for injury governs the analysis to determine the amount entitled to administrative expense priority.

These examples show that appropriate contract principles, such as restitution, focus on the injury to the nondebtor party that performs under the contract pending the debtor's perform/breach decision. Because damages are based on restoring the injured party to the position the party would have enjoyed absent the injury caused by the debtor's delay, determining damages entitled to administrative expense priority under these contract remedies often has no specific connection with the contract price.⁽¹¹³⁹⁾ Other contract principles, such as the duty to mitigate, would be equally applicable in cases involving interim compensation. Compensation is designed to be remedial and to minimize the adverse consequences of a delay in the decision to breach or perform.

Competing Considerations. Courts continue to try to develop their own remedies to deal with the consequences of delay in contract decisions, perhaps obviating the need for a statutory solution in this area. However, different approaches in the case law and the reports of many practitioners seem to indicate that guidance would be exceedingly helpful, particularly to promote uniform treatment of nondebtor parties by focusing the inquiry on the nondebtor party's injury. In addition to decreasing costs and uncertainty, the Commission's Recommendation to provide specific guidelines would reduce disparate treatment of similarly situated creditors who currently are compensated in different amounts for their temporary performance.

Under this Proposal, courts would assume the difficult task of fashioning interim relief. Interpreting a contract and balancing and protecting the interests of both parties can be a complex undertaking in many cases. Although the contract price might be used presumptively whenever possible, the payment structure or the nature of some contracts may require more challenging determinations of what would constitute fair compensation for interim performance. The problem is not new to bankruptcy courts, which presently conduct some of this analysis in establishing administrative expense priority claims and in other contexts, but the proposed change presents an additional challenge by focusing directly on the costs to the nondebtor party.

Some are concerned that compensation for damages sustained during an interim performance would entail litigation to determine the appropriate amount to be awarded to the nondebtor party. Because contract law inevitably relies on litigation to determine the proper damage award, this criticism is unavoidable, regardless of the method of calculation. No measure of damages for interim relief--including the contract price--can avoid litigation. If interim relief is based on the contract price, for example, the parties face potential litigation to determine the appropriate fraction of the contract price to be awarded. There is no contract theory that splits contract prices to guide the courts. For example, a court would have to determine what portion of the contract price a party should receive under an agreement creating a future obligation to perform services or to sell goods. A contract-based remedy, such as restitution, clarifies the factual inquiry for the court and provides a principled basis for the award of damages. Regardless of the prescribed method of determination, awarding appropriate damages to the nondebtor party comes at the cost of a factual inquiry. This is a necessary cost if the nondebtor party is to be fairly compensated.

To the extent that nondebtor parties currently seek and obtain the imposition of time limits to elect to perform/breach/transfer, these parties might obtain less conclusive relief during the pendency of the case. However, the deferral of binding decisions is often in the best interests of all parties, assuming that nondebtor parties are assured of compensation during the interim period.

The adoption of this Proposal might call into question the continuing need for a provision exclusively governing the trustee's obligations to perform under a lease for nonresidential real property pending an election to perform or breach.⁽¹¹⁴⁰⁾ The Commission did not specifically consider this question, although the interaction of general proposals with special interest legislation is a continuing theme throughout these proposals. Indeed, as noted earlier in this discussion, the presence of specially applicable legislation combined with improved generic language may create new difficulties both for the special cases and for the general cases.

2.4.4 Contracts Subject to Section 365; Eliminating the "Executory" Requirement

As the previous discussions have explored, section 365 of the Bankruptcy Code governs the "assumption" (performance), "rejection" (breach), and "assignment" (transfer) of contracts and leases in bankruptcy. Because section 365 currently refers to executory contracts and not to all contracts, commencing the inquiry on the appropriate disposition of a contract depends on whether the parties believe and the court determines that the contract is "executory."⁽¹¹⁴¹⁾

Development of the Bankruptcy Term "Executory." Under nonbankruptcy law, the term "executory" is a broad modifier, referring to all contracts not fully performed.⁽¹¹⁴²⁾ Bankruptcy law has developed a different interpretation of the term starting well before the enactment of the Bankruptcy Code of 1978. Section 365 is derived from section 70b of the Bankruptcy Act of 1898, a provision that codified judicially created rules allowing a trustee to reject the debtor's economically burdensome contracts and assume and perform economically beneficial leases or executory contracts.⁽¹¹⁴³⁾ The Bankruptcy Act offered very little additional guidance for dealing with executory contracts. If courts did not supervise contract dealings, an estate improvidently could become obligated to perform contracts to the detriment of other creditors. For example, a debtor in possession could prefer one unsecured creditor over all others by assuming a debt obligation that then would be entitled to full repayment. To avoid this result, courts developed a more restrictive interpretation of the term "executory" for bankruptcy purposes to ensure contracts would be assumed only if economically beneficial for the estate. However, by many accounts, those approaches were not always consistent.⁽¹¹⁴⁴⁾ To ameliorate some of this confusion, Professor Vern Countryman articulated the following "material breach" analysis to identify an "executory" contract that could be assumed or rejected:

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.⁽¹¹⁴⁵⁾

Using the material breach test, courts gauged remaining future performance of both the debtor and the nondebtor to determine whether the estate would benefit by becoming administratively obligated to perform. The 1973 Report of the Commission on the Bankruptcy Laws of the United States indicated that "executory" referred to incompletely performed agreements but did not endorse a succinct statutory definition.⁽¹¹⁴⁶⁾ Congress declined to define "executory contract" when it enacted section 365 of the Bankruptcy Code. According to the legislative history, executory contracts were those in which "performance remains due on both sides."⁽¹¹⁴⁷⁾

It seems clear that the requirement of executoriness was developed in large part to prevent unwise or inadvertent assumptions or rejections by trustees, because under the Bankruptcy Act of 1898 there was no requirement of court approval and notice to creditors for those actions. The Bankruptcy Reform Act of 1978 closed that gap by requiring court approval for assumption or rejection, largely eliminating the underlying reason for the constraining concept.⁽¹¹⁴⁸⁾ Even using a deferential business judgment standard commonly employed by courts in reviewing motions to assume or reject, a trustee cannot assume a contract if the benefits to the estate clearly were outweighed by the burdens.⁽¹¹⁴⁹⁾ The goal to be served by the executoriness test is now met directly by court review.

A growing case law trend de-emphasizes a strict analysis of the term "executory" in favor of a "functional" analysis, an approach articulated by Professor Jay Westbrook, Michael Andrew, and others ⁽¹¹⁵⁰⁾ Using a functional analysis, a court does not consider remaining mutual material performance but instead considers the goals that assumption or rejection were expected to accomplish: enhancement of the estate.⁽¹¹⁵¹⁾ Under this approach, the term "executory" ultimately serves no purpose, for the executory or nonexecutory label is an after-the-fact description designed to fit the court's conclusions about the value of the contract to the estate. Recognizing this fact, a few courts taking the functional approach have declined to make the threshold finding of executoriness at all and simply have focused on whether the estate would be benefitted by performance or breach. Likewise, some courts have taken circuitous analytical routes to avoid lost value that would result from a rigid application of the executory requirement.⁽¹¹⁵²⁾

The term "executory" is not merely harmless surplusage. First, even though courts decide that a functional analysis of contracts is analytically superior and yields results more consistent with bankruptcy policy objectives, such analysis would appear to depart from the statutory guidelines. To use an arguably more efficient approach, a statutory amendment is advisable to assure that shift and to cause all courts to follow the same route. Second, few would dispute the persistent inconsistencies and difficulties in identifying an executory contract for bankruptcy purposes, a condition that is exacerbated as courts use different tests to identify an executory contract. Finally, the traditional strict interpretation of the executory requirement leads some courts to results that contravene the initial purpose of the restriction because it does not isolate valuable contracts and does not preclude improvident elections to perform or breach.⁽¹¹⁵³⁾ Some very valuable contracts may be unassumable on account of a strict executory test.⁽¹¹⁵⁴⁾ An executoriness analysis therefore can hamper the process of permitting the bankruptcy estate to elect to perform contracts that will be highly beneficial.

So long as the term "executory" remains in the statute, this issue will continue to incite debate and to increase litigation costs without an evident corresponding advantage.⁽¹¹⁵⁵⁾ Therefore, the Commission recommends the elimination of all references to the term "executory." This change would not alter the other substantive parameters of section 365 such as the statutory exclusion of loan and financial accommodation contracts.⁽¹¹⁵⁶⁾ Rather, the Proposal would streamline the analysis of the debtor's contracts and provide a directive to courts to analyze the relevant considerations guiding one's decision to perform, breach, or transfer a contract, just as a contracting party would do outside of bankruptcy. By putting all contracts on the same track for analysis rather than creating distinctive groups of creditors with uncertain rights (e.g., the limbo state of the undefined class of contracts found to be nonexecutory),⁽¹¹⁵⁷⁾ the Proposal would promote the goal of equality of treatment among creditors.⁽¹¹⁵⁸⁾ Moreover, this Proposal bypasses the nonuniformity created by the threshold question of executoriness and thus is fairer to all parties.

Competing Considerations. Notwithstanding recent case law developments that de-emphasize the executory requirement, some might be concerned that eliminating any term already in use, including "executory," could have an unsettling effect on case law and thereby encourage new litigation. However, this Proposal would not introduce a foreign concept, but rather would streamline the analysis so that courts can focus on the critical issue of the benefit to the estate, which originally was the intended goal of the executoriness requirement.⁽¹¹⁵⁹⁾

No proposal in this area of the law can eliminate all litigation because court approval is a crucial component and the review of the perform-or-breach-election is an assessment based on the facts and circumstances of each case and each contract. The removal of the threshold executory requirement would permit courts to focus on pertinent case- and estate-related factors and would curtail litigation on tangential issues relating to the term "executory." By eliminating this source of confusion, costs and unnecessary delays should be minimized.

2.4.5 Prebankruptcy Waivers of Bankruptcy Code Provisions

Bankruptcy is a collective statutory remedy for debtors and creditors alike. Unlike a regular civil lawsuit between two parties that freely permits private settlement agreements within reasonable boundaries, bankruptcy law anticipates that the debtor cannot form private agreements circumventing the statutory provisions that protect all parties in the collective action. Similarly, nonbankruptcy commercial law systems generally refuse to recognize debtors'advance waivers of statutory rights or obligations related to enforcement of remedies or debt collection. Parties in secured transactions, for example, cannot execute loan documents that waive certain standards and constraints on collection remedies provided by Article 9 of the Uniform Commercial Code at a time when they cannot fully appreciate the consequences.⁽¹¹⁶⁰⁾ In the same way, procedures and remedies provided in state mortgage foreclosure laws generally cannot be waived in advance of a default.⁽¹¹⁶¹⁾

While it was long assumed that specific rights, effects, or obligations provided by the Bankruptcy Code could not be waived in advance even in the absence of an express nonwaivability Code provision, case law and business practice have begun to call this long-held assumption into question. With increasing regularity, loan documents and workout agreements contain clauses waiving the applicability of the automatic stay if the borrower files for bankruptcy. The agreement may contain a clause providing that "the borrower will not oppose the lender's motion" to obtain relief from the automatic stay or admitting that the collateral is "not necessary to an effective reorganization."⁽¹¹⁶²⁾

This issue has not yet produced an overwhelming number of published decisions, but the decisions thus far create significant uncertainty.⁽¹¹⁶³⁾ Apparently, no court has found a waiver to be self-executing,⁽¹¹⁶⁴⁾ and some courts have held that waivers are unenforceable.⁽¹¹⁶⁵⁾ Yet, other courts have enforced these provisions on request or have held that these provisions are enforceable in some circumstances.⁽¹¹⁶⁶⁾

Courts advocating the enforceability of such waivers argue that refusing to enforce waivers would deter out-of-court workouts. Looking beyond the overlay of a collective bankruptcy proceeding, they have reasoned that the contractual provision must be upheld in the absence of grounds for rescission. Likewise, courts have reasoned that the debtor is not conclusively entitled to protections such as the automatic stay throughout the entire course of the case, and they have contended that waiving one component of bankruptcy is permissible since the debtor would remain free to use whatever other tools the debtor has not bargained away.⁽¹¹⁶⁷⁾

These clauses are problematic for several reasons, many of which have been identified by courts declining to enforce waiver clauses. First, the statutory rights of creditors should not be altered by prepetition actions of the debtor.⁽¹¹⁶⁸⁾ The automatic stay, a frequent subject of prebankruptcy waivers, is one of the most fundamental components of bankruptcy that stops the "inefficient dismembering of the debtor" by individual collection efforts and thus promotes the orderly and efficient administration of the estate for the benefit of all creditors.⁽¹¹⁶⁹⁾ If a debtor could limit the scope of the automatic stay, the interests of other creditors could be severely undermined.⁽¹¹⁷⁰⁾ With these types of considerations in mind, bankruptcy law and policy generally do not permit parties to make prebankruptcy contracts that affect the postbankruptcy rights of third parties. For example, section 541(c) of the Bankruptcy Code expressly invalidates certain prebankruptcy agreements that preclude property from becoming property of the estate available for distribution to all creditors.⁽¹¹⁷¹⁾ Bankruptcy law also explicitly prohibits parties from making private agreements to avoid the consequences of bankruptcy. In its governance of non-loan executory contracts and leases, section 365 renders unenforceable contract provisions that in any way extend the rights of the nondebtor party in the event of the debtor's bankruptcy.⁽¹¹⁷²⁾

The ability of one creditor to negotiate privately with the debtor for special treatment in bankruptcy runs counter to the principle of equitable treatment and could have significant distributional consequences for all other creditors. The creditors on whom this falls hardest are those who are least likely to be at the bargaining table, such as trade creditors, tort victims, environmental claimants, and employees. These kinds of creditors only stand to lose from the enforceability of such clauses. Far from giving contractual claimants enhanced rights in bankruptcy, the Bankruptcy Code generally strives to limit the rights of contractual creditors to promote equality of treatment among creditors. Claims for unmatured interest that may be perfectly valid outside of bankruptcy are unavailable in certain circumstances under section 502; bankruptcy law often overrides negotiated deals outside of bankruptcy that let one creditor collect a high percentage of interest while another collects nothing while the bankruptcy case is pending. Likewise, Congress also decided to limit secured parties' rights in after-acquired property of a debtor in bankruptcy.⁽¹¹⁷³⁾

Beyond the problem of prepetition agreements affecting equality of distribution, it is questionable whether the prepetition debtor has the legal capacity to make decisions about the application of the bankruptcy laws that are binding on the bankruptcy estate. The debtor could not bind the trustee in a Chapter 7 liquidation by waiving in advance the estate's right to an automatic stay. At least one court has taken the view that the prepetition debtor similarly cannot bind the debtor in possession, which is given the rights and duties of the trustee in bankruptcy and is vested with an independent fiduciary obligation to act in the best interest of the bankruptcy estate.⁽¹¹⁷⁴⁾ Prepetition debtors frequently are controlled by different parties than postpetition debtors. Management often is replaced in large Chapter 11 cases.⁽¹¹⁷⁵⁾ An ailing business can be put in the hands of turnaround management to help resolve economic and operational problems. Some debtors in possession are replaced by Chapter 11 trustees "for cause."⁽¹¹⁷⁶⁾ To what extent should these parties, some of whom are vested with fiduciary duties to the estate as well as statutory obligations, be able to disregard their duties on account of a prepetition agreement between two parties? Congress' comprehensive statutory scheme should not be circumvented by a debtor's prepetition agreement with one creditor, or even a few creditors, to waive the applicability of a bankruptcy provision.⁽¹¹⁷⁷⁾ Parties should not expect enforcement of a contract that contravenes the Bankruptcy Code's policies and requirements since bankruptcy is a collective proceeding governed by federal statute.

The bankruptcy system provides clear rules of priority and protection on which all parties can rely to determine the treatment that will be accorded to certain types of creditors.⁽¹¹⁷⁸⁾ The statutory priority scheme is part of the burden and benefit of a bankruptcy case and should not be subject to reconstitution by prior agreement or court order entered outside of bankruptcy proceeding. To function properly and fairly, the priority scheme should supplant private agreements or transactions that specifically do not comport with the statutory rules, notwithstanding the good faith of the parties. To further the principles underlying the priority scheme, certain prebankruptcy transactions can be set aside or avoided under sections 544, 546, 547, and 548, often for failure to comply with nonbankruptcy requirements, such as those to perfect security interests under Article 9 of the Uniform Commercial Code.

This discussion should not be construed to mean that bankruptcy law should never recognize the prebankruptcy actions of parties. Indeed, at their core, many bankruptcy law priorities are premised on negotiated bilateral agreements, so long as they follow a conventional path and comply with requirements for notice and other applicable protections. For example, if voluntary creditors wish to obtain preferred treatment in the event of a borrower's bankruptcy, they can take security interests in compliance with the requirements of Article 9 of the Uniform Commercial Code rather than lending on an unsecured basis, as long as they do not do so on the eve of bankruptcy to circumvent the priorities without providing new money or present consideration.⁽¹¹⁷⁹⁾ They should not, however, be able to bargain with the prepetition debtor to be treated in a way that violates the Bankruptcy Code's priority scheme.⁽¹¹⁸⁰⁾

Moreover, even if these contract clauses were potentially enforceable, they cannot be distinguished from other contracts that are subject to breach under section 365 of the Bankruptcy Code. As previously discussed, under section 365, the trustee assesses whether to elect to perform or breach the contract and the judge scrutinizes the trustee's decision, based on the best interest of the estate. Although breached contracts are not "avoided," the nondebtor contract party rarely is entitled to specific performance, and instead receives damages in a pro rata distribution along with creditors of similar priority.⁽¹¹⁸¹⁾

Even in decisions that uphold waivers of the automatic stay, there is a consistent theme that calls into question the need for such provisions and confuses their application: those courts conclude that the facts of those cases meet the grounds for lifting the stay under section 362(d)(1) or for dismissal under sections 1112 or 305.⁽¹¹⁸²⁾ Yet, the courts then uphold the prepetition contractual waivers, despite the fact that they contain different bases for lifting the automatic stay from these statutory grounds. Accordingly, the support for contract waivers is dicta in virtually every case. Because the courts refer to both the statutory elements and the contract and thus provide multiple grounds for their decisions, the waivers are not averting litigation, but are compounding the confusion on what is required.

Waiver cases may have a pernicious effect on doctrinal development. For example, some opinions indicate that they uphold the waivers because "dead on arrival" single asset real estate cases are being filed in bad faith. However, these cases are cited for precedential value in other types of cases, including consumer cases dealing with home mortgages.⁽¹¹⁸³⁾ Bad faith bankruptcy filings should be addressed directly, and if circumstances reveal that these cases have no hope of reorganization, the Code already provides a variety of potential responses that deal with the problem at hand without introducing additional uncertainty, cost, and litigation into the system for future cases.

At the same time, with the prospect of potential enforceability, lenders increasingly include contingencies in loan documents, indentures, and workout, forbearance, and settlement agreements that waive certain rights of the borrower upon filing for bankruptcy.⁽¹¹⁸⁴⁾ The possible enforceability of prebankruptcy waivers pervasively affects a wide range of private negotiations between lenders and borrowers of every size, from the largest businesses to individual borrowers, both before and after a waiver is incorporated into a loan or workout agreement. Although counsel for both borrower and lender probably know that the enforceability of such waivers is questionable, and counsel typically will not give a legal opinion letter on the enforceability of such waivers, waivers are becoming boilerplate language in loan documentation. The borrower usually is not in a position to insist that the clause be stricken from the agreement.⁽¹¹⁸⁵⁾

The Commission's proposed amendment would clarify that waivers of the automatic stay and similar provisions in prebankruptcy contracts of the debtor are not effective to limit or alter provisions of Title 11. The Recommendation contains generic language because the waivers at issue do not exclusively involve the automatic stay or any other specific provision, and lawyers are sufficiently creative to devise alternative approaches to accomplish the same result. Thus, the statute should address the principle of prohibiting prebankruptcy waivers and not limit this directive to any specific form of waiver. Because waivers also appear in prior plans of reorganization, dismissal orders, and potentially in other court orders, it is important that such prebankruptcy waivers be made ineffective when presented in those forms. A bankruptcy court is free to consider the circumstances surrounding a prior workout attempt in the same way that a court can review the prior business history to appreciate fully the current circumstances and future projections of the debtor.

This Proposal is not intended to alter the preclusive effect of judgments generally. For example, a debtor who has been proven guilty of a substantive allegation that would make a debt nondischargeable, such as civil fraud, could not use this provision to relitigate the facts in a bankruptcy action over nondischargeability. This provision would not require duplicate litigation on substantive matters when issues already have been determined in a nonbankruptcy forum and when those final orders would have preclusive effect. The recommended provision also contains an exception regarding settlements with the government in its police or regulatory capacity, on the assumption that these type of settlements would not involve the waiver of bankruptcy rights and protections that have been the subject of this discussion.

Competing Considerations. Although the Commission's Recommendation is consistent with the general tenet precluding advance waivers of statutory rights and remedies and with the intention of Congress to restrict the enforcement of contractual rights in bankruptcy,⁽¹¹⁸⁶⁾ freedom of contract often is raised as a contrary consideration for this type of proposal. The freedom of contract argument states that it is more efficient for parties to specify their own remedies in advance rather than using remedies provided by statute.⁽¹¹⁸⁷⁾ A freedom of contract argument presumes from the outset that all parties were represented at the bargaining table and unanimously agreed to the remedies set forth, relatively unlikely circumstances for most business dealings.⁽¹¹⁸⁸⁾ Even if this set of circumstances existed, however, it is highly improbable that parties can accurately predict adequate relief given the myriad unforeseeable consequences that might accompany the debtor's financial collapse at an unknown point in the future. Bankruptcy is designed to provide a structure to deal with unforeseeable events with third party consequences that cannot be replaced by two-party arrangements. Provisions that cannot be waived until the time of default are not unusual in commercial law. Even in two-party agreements, the law recognizes that some rules should not be waivable until events have unfolded and all the parties can appreciate the implications of waiver.

Others argue that enforcing waivers would promote out-of-court workouts.⁽¹¹⁸⁹⁾ The Commission supports out-of-court workouts and has sought to make recommendations that will clarify legal questions to facilitate such negotiations, which can be less costly and more efficient. The Commission also has recommended provisions to promote the use of prepackaged plans of reorganization. However, waivers of bankruptcy rights do not necessarily promote efficiency. Because one cannot agree with a creditor to waive the right to file for bankruptcy in advance,⁽¹¹⁹⁰⁾ and waivers of specific bankruptcy rights are not self-executing, waivers are not an efficient device to avoid litigation. Even if waivers were not invalid per se, parties still would find themselves in bankruptcy court litigating over the enforceability of particular clauses based on the circumstances of each case.⁽¹¹⁹¹⁾ It may be more expedient to proceed with a lift-stay motion solely on the statutorily-provided grounds rather than having the court do a retrospective analysis of the validity of the waiver. Instead, any "efficiency" created by waivers is due to the leverage they wield for one creditor, not due to the overall promotion of out-of-court workouts.

Limited use of waivers in postdefault situations to promote workouts actually could have an effect opposite to what was intended. There already is evidence that secured creditors have begun to regard a postdefault waiver of bankruptcy as a routine component in lending arrangements and such clauses have been routinely included in so-called boilerplate language in loan agreements. If waivers were enforced routinely, creditors might become more insistent that waivers be signed early in an episode of financial distress. If this becomes standard business practice, workouts would become unattractive alternatives for well-advised debtors, perhaps prompting them to file Chapter 11 immediately, rather than signing these agreements. In that case, the workout alternative would be eliminated in many cases.

2.4.6 Prepackaged Plans of Reorganization; Section 341 Meeting of Creditors

A method of encouraging workouts that is consistent with the bankruptcy system is the use of prepackaged plans of reorganization. A "prepack" is an efficient approach to Chapter 11 that can be very useful for businesses that need financial reorganization but that do not need operational restructuring or longterm protection of the bankruptcy laws. In an ordinary Chapter 11 case, the debtor files, obtains approval of its disclosure statement, solicits votes, and seeks to have the plan confirmed. The objective of a prepackaged bankruptcy case is to negotiate the terms of a financial restructuring in advance of filing and to come into the bankruptcy system ready to confirm a plan. A business works out a plan and solicits votes. Assuming it received the requisite support, the business files for bankruptcy with a potentially confirmable plan in hand and with most of the difficult negotiation already completed. The filing of the petition usually signifies that the majority of the creditors support the proposed plan. The debtor merely needs one or more of the legal mechanisms of title 11 to effectuate the agreement. The debtor that has used a prepack can emerge from bankruptcy within a few months, or even in weeks, and can lower the transaction costs of bankruptcy significantly.

The issue in this Proposal is the applicability of section 341 of the Bankruptcy Code to prepacks. Section 341 requires the U.S. trustee to convene a meeting of creditors in every bankruptcy case.⁽¹¹⁹²⁾ The Federal Rules of Bankruptcy Procedure establish that in Chapter 7 or Chapter 11 cases, the meeting must be held within twenty to forty days after the court enters an order for relief.⁽¹¹⁹³⁾ In theory, this meeting provides creditors with a meaningful opportunity to examine the debtor and to obtain important information. However, when parties negotiated and voted on the plan before the debtor even filed a bankruptcy petition, creditors are not likely to receive any significant benefit from the section 341 meeting. Instead, holding the required meeting only delays confirmation significantly without fulfilling its intended function. According to attorneys familiar with the procedure, in some prepacks, the U.S. trustee convenes section 341 meetings only to comply with section 341, while in other prepacks, the U.S. trustee does not hold section 341 meetings, which technically violates section 341.

Holding the section 341 meeting in a prepack case entails an unnecessary and costly time delay because the creditors already have received disclosures from the debtor and support the plan. In a consensual case that otherwise could be confirmed in a day or two, the notice and scheduling requirements for a section 341 meeting can forestall confirmation for at least twenty days. Some parties have reported that the time delay is particularly crucial in a case with transnational implications because of the risk that local authorities in other countries will seize assets of the estate if the case is not resolved on an expedited basis.

The Commission recommends that section 341 be amended so that the section 341 meeting of creditors is not required in prepacks, as long as the court agrees.⁽¹¹⁹⁴⁾ Court discretion would not be cumbersome in this situation, but is important to ensure that the meeting is held if circumstances so require. At the same time, this Proposal would permit any party in interest to request the waiver of the meeting rather than leaving this initial request in the hands of only one party, such as the U.S. trustee. The Proposal is designed to prevent unneeded delays in the Chapter 11 prepack process to minimize cost and to increase efficiency.

The efficacy of the section 341 meeting has been questioned in many contexts outside the context of prepacks. However, this Proposal addresses only the narrow situation of a prepack and does not express an opinion on the use of section 341 meetings in other types of cases.

Competing Considerations. Some might argue that the section 341 meeting serves a structural function and thus should not be subject to waiver, even with court approval. However, because this Proposal preserves court discretion, any benefits of this structural function most likely are outweighed by countervailing benefits.

2.4.7 Authorization for Local Mediation Programs

Another method of encouraging workouts and reducing unnecessary costs of the bankruptcy process is through the use of mediation, a lower-cost, higher-satisfaction alternative to litigation. Not to be confused with arbitration, mediation is a non-binding process using a neutral party to encourage discussion and negotiation that might ultimately narrow or obviate the need for protracted litigation. Mediation offers litigants the opportunity to resolve disputes creatively and provides a catalyst for settlement, while reducing the costs, delay, and burdens that often accompany litigation or the plan negotiation process.⁽¹¹⁹⁵⁾ Both Congress and many judicial districts have endorsed cost minimization through case management techniques and alternative dispute resolution. While it may not be directly applicable to bankruptcy courts, Congress enacted the Civil Justice Reform Act of 1990,⁽¹¹⁹⁶⁾ which set the groundwork for alternative dispute resolution programs in the district courts.

A considerable number of districts have implemented mediation programs for disputes that arise in bankruptcy cases and adversary proceedings.⁽¹¹⁹⁷⁾ The programs are in various stages of development. The Southern District of California, for example, established its mediation program in 1986, while the Northern District of Illinois recently made the necessary local bankruptcy rule changes to implement a voluntary mediation program. However, while the Bankruptcy Rules currently provide for consensual and binding arbitration,⁽¹¹⁹⁸⁾ neither the Bankruptcy Code nor Federal Rules of Bankruptcy Procedure authorize the use of mediation programs. Courts have used their "inherent power,"⁽¹¹⁹⁹⁾ the Civil Justice Reform Act, or courts' general equitable power under section 105 of the Bankruptcy Code to establish mediation programs that presently are reducing costs and successfully facilitating the resolution of disputes.⁽¹²⁰⁰⁾ The programs have been successful in resolving numerous issues and disputes involving claims, adversary proceedings, and plan issues. While mediation attempts will not eliminate litigation in all cases, mediation can help to narrow the issues in dispute. This process can be effective for discrete matters that may arise during the course of a bankruptcy case. The plan negotiation process for large and complex cases also can benefit from mediation, which provides a means for bringing many parties to the bargaining table.⁽¹²⁰¹⁾ Mediation should be available in small cases as well for the same types of reasons.

The Commission recommends that the Judicial Code and the Federal Rules of Bankruptcy Procedure authorize mediation in bankruptcy cases, contested matters, and adversary proceedings. This recommendation should enhance the goals of maximizing payments to creditors and the reorganization effort by minimizing the costs of bankruptcy administration that often are increased by protracted litigation. The Proposal would authorize judges to order parties to attempt mediation. Otherwise, one party in a dispute could withhold consent as a litigation tactic, leverage tool, or for purposes of delay. Because mediation is not binding and entails only a good faith effort by the parties, ordering parties to meet with a mediator should not unduly prejudice any litigant. Some existing mediation programs direct mandatory non-binding mediation with few problems.

While the nationwide authorization of mediation would provide a uniform structural basis, the Commission suggests that most details be left to local rules. With the basic framework in place, districts can determine what type of program best serves their needs, which may depend in part on the types of cases or disputes that dominate their dockets and that experience suggests are well suited for mediation. Although all districts should set standards on the qualifications for mediators, the types of cases in various districts might dictate what those standards should be. The mediator selection process in particular cases also can be determined locally.

One detail that federal law should address is the authorization of courts to approve payment of a mediator from assets of the bankruptcy estate. Some programs already provide for the payment of mediators, but statutory authority is the proper way to authorize payment. The Commission does not intend to discourage the use of pro bono mediation. Currently, the local rules of certain paid mediation programs require mediators to do some pro bono mediation, suggesting that both paid and unpaid mediation services may be integrated successfully, and both are important parts of a functional mediation program.

It is unnecessary to delineate the types of matters suitable for mediation. Bankruptcy courts are best able to make this determination in the cases before them, and districts could restrict the range of subject matter in their mediation programs if they thought it appropriate. However, the Commission believes that two types of disputes should not be subject to mediation: issues surrounding the retention or payment of professionals ⁽¹²⁰²⁾ and matters involving contempt of court, sanctions, or other judicial disciplinary actions. These types of disputes involve issues that belong before the court exclusively for judicial resolution.

Competing Considerations. Because many districts already have established mediation programs, some people question whether specific statutory authority is necessary. In addition, some people may have reservations about authorizing courts to mandate mediation if the parties do not consent. One could argue that strategic requests for mediation could be employed as a delay tactic that would drive up costs, counter to the intent of the mediation programs. Clearly, courts should not order mediation in instances when mediation would be a fruitless and time-draining undertaking.

2.4.8 Court Review of Appointments to Creditors' Committees

Subsection (a)(2) of 11 U.S.C. §1102, "Creditors' and equity security holders' committees," should be amended to read as follows:

Committees of unsecured creditors represent and protect the economic interests of unsecured creditors in the Chapter 11 reorganization process.⁽¹²⁰³⁾ In large cases, the creditors' committee is likely to be the primary vehicle for unsecured creditors to voice their concerns effectively and to negotiate with the debtor and other creditors.⁽¹²⁰⁴⁾ The committee is intended to provide "dynamic tension" to stimulate productive reorganization efforts through negotiation and oversight.⁽¹²⁰⁵⁾ A creditors' committee wields significant influence in the negotiation of a Chapter 11 case and is a key player in the plan negotiation process.⁽¹²⁰⁶⁾ Therefore, the composition of a creditors' committee is a significant component of a Chapter 11 case. The Bankruptcy Code guides, but does not mandate, the membership of a committee by stating that the committee "shall ordinarily consist" of the holders of the seven largest claims of the kind represented by the committee.

A problem arises when unsecured creditors believe that they are not adequately represented by the unsecured creditors' committee. Creditors serving as committee members owe a fiduciary duty to the unsecured creditors at large whom they represent.⁽¹²⁰⁷⁾ Yet, it is rare for a committee to be challenged for failing to satisfy its duty and to exercise its statutory powers.⁽¹²⁰⁸⁾ To provide adequate representation of the interests of different unsecured creditors, a bankruptcy case might need to have more than one committee of unsecured creditors.⁽¹²⁰⁹⁾ However, because expenses of a creditors' committee are borne by the bankruptcy estate, additional committees are the exception and not the rule.⁽¹²¹⁰⁾ For example, cases with mass tort liabilities might have a tort claimants' committee and another unsecured creditors' committee representing trade and other conventional unsecured creditors.⁽¹²¹¹⁾ A solvent debtor with a large number of equity holders might need an equity committee, while a case with a highly complex debt structure might warrant additional creditors' committees to represent different priority creditor interests. Absent these circumstances, the Chapter 11 system contemplates that one committee accommodate the differences between the members of unsecured creditors community and the size of their debts.⁽¹²¹²⁾

However appropriate committee appointments might appear at the inception of a case, the committee composition may turn out to be inappropriate. Unsecured creditors may sell their claims to outsiders or to other creditors. Some contingent claims may disappear as debtors agree to perform contracts under section 365. New conflicts among creditors emerge as old conflicts disappear. If creditors can show that the committee inadequately represents creditor interests, the most narrowly tailored solution would be to order the adjustment of that committee rather than the appointment of a separate committee. Currently, the law does not clearly provide for such relief.

History of Committee Appointments. Under the Bankruptcy Act of 1898, creditors selected the members of their representative committees.⁽¹²¹³⁾ When Congress altered the business reorganization process in the Bankruptcy Code of 1978, courts became responsible for appointing committees of unsecured creditors in Chapter 11 cases. If parties raised objections to the composition of the creditors' committee, courts could revisit their own appointment decisions and could change the size or membership of committees.⁽¹²¹⁴⁾

The U. S. trustee system was established nationwide in all federal judicial districts except those in Alabama and North Carolina under the 1986 amendments to the Bankruptcy Code.⁽¹²¹⁵⁾ The U.S. trustee system assumed responsibility for the administrative functions, including various case appointments, to reduce the appearance of impropriety that sometimes resulted when judges made appointments.⁽¹²¹⁶⁾ Congress transferred the "administrative task" of appointing committee members from the courts to the U.S. trustee. When section 1104 of the Code was amended to reflect this change, Congress also repealed the provision that had authorized courts to review their own committee appointments, section 1102(c), and did not replace the section with a reasonably analogous substitute. The resulting statute thus was unclear about whether a court can review the U.S. trustee's committee appointments, and if so, what standard of review is appropriate. Although ten years have elapsed since the passage of the amendments to section 1102, it remains uncertain whether courts can review the U.S. trustee's committee appointment decisions, thereby producing a variety of results.⁽¹²¹⁷⁾

As stated previously, the Bankruptcy Code explicitly authorizes courts to order the appointment of additional committees of unsecured creditors to ensure "adequate representation."⁽¹²¹⁸⁾ Parties need not pursue the issue with the U.S. trustee before turning to the court.⁽¹²¹⁹⁾ Reading these provisions literally, only one tool is available for courts to remedy inadequate representation: they can impose an additional financial burden on the estate by requiring the appointment of additional committees rather than taking the more modest step of ordering the alteration of the existing creditors' committee.⁽¹²²⁰⁾

Judicial Interpretation of Availability of Court Review. In considering the question of whether courts can review creditors' committee appointments, some courts have held that section 1102 literally does not authorize this court review.⁽¹²²¹⁾ According to this view, creation of an additional committee is the only recourse that the Bankruptcy Code provides to remedy inadequate representation.⁽¹²²²⁾

Other courts do not accept this result. They refuse to impose the burden and expense of creating additional committees to remedy inadequate representation when altering the composition of an existing committee would be more suitable.⁽¹²²³⁾ Other courts have asserted that Congress presumptively intended judicial review of administrative actions absent convincing evidence of a contrary intent.⁽¹²²⁴⁾

In reviewing appointments, these courts apply disparate standards on the merits. Some courts have applied "abuse of discretion" or "arbitrary or capricious" standards ⁽¹²²⁵⁾ principally based on the authority of section 105(a),⁽¹²²⁶⁾ which empowers courts to issue any order, process, or judgment necessary to effectuate the provisions of title 11.⁽¹²²⁷⁾ In essence, courts taking this view require that the movant provide substantial evidence that the U.S. trustee acted arbitrarily and capriciously in its appointment decisions.⁽¹²²⁸⁾ This approach fails to provide a tool to deal with decisions that may have been sensible when made, but that are rendered inappropriate by subsequent events.

Rather than spending time reviewing the arbitrariness of the U.S. trustee's decision, other courts simply have reviewed the committee composition to determine directly if the committee is adequately representative.⁽¹²²⁹⁾ These courts hold that this approach does not undermine Congressional intent to delegate administrative or ministerial functions to the U.S. trustee, since adequacy of representation is a legal issue and thus inherently falls within the power of the courts.

The Commission recommends that section 1102(a) of the Bankruptcy Code be amended to authorize courts to review creditors' committee composition and the qualifications of the members for purposes of ensuring that the committees are adequately representative, just as courts were entitled to do prior to the 1986 amendments. This change would ameliorate needless uncertainty on this important creditors' committee issue.⁽¹²³⁰⁾ On motion of a party in interest and after notice and a hearing, a court would render an independent decision as to whether the creditors' committee was adequately representative and would order the U.S. trustee to adjust membership if necessary.⁽¹²³¹⁾

Implicit in this Recommendation is the recognition that the establishment and composition of creditors' committees raise issues that go beyond those administrative responsibilities that fall within the exclusive province of the U.S. trustee. The U.S. trustee is not required to engage in specific procedures for committee appointments and makes no specific findings as to adequate representation, either with respect to the number of committees or the composition of the committees. Rather, the U.S. trustee is required to establish merely that a potential committee member is an unsecured creditor and is willing to serve on the committee.⁽¹²³²⁾ However, because committee composition invokes a significant question of law, adequate representation, the Commission believes that de novo review is appropriate when considering the representative nature of existing committees.⁽¹²³³⁾ De novo review also is the level of scrutiny exercised by courts when they consider the necessity of additional committees,⁽¹²³⁴⁾ and therefore courts could consolidate challenges to committee composition and requests for additional committees, which involve similar, if not identical, legal and factual issues.

This Proposal should not be construed as promoting any diminution in the role of the U.S. trustee. Rather, this Recommendation is consistent with the intent of Congress to vest the U.S. trustee with responsibility for ministerial matters associated with creditors' committees while courts retain primary responsibility for resolving legal disputes.

Competing Considerations. Some might prefer the implementation of an arbitrary and capricious standard to review the U.S. trustees' committee appointments. The Commission endorsed the de novo standard because of the underlying legal issues, because the U.S. trustee would remain responsible for the actual appointment of committee members, and because plenary review would not be significantly more cumbersome for the courts than the abuse of discretion standard. In addition, using the de novo standard closes any gap between a creditor's entitlement for relief through readjustment of the standing committee and the more costly remedy of relief through appointment of a new committee. In addition, a review of the case law and commentary suggests that there is no significant difference between de novo review and use of the arbitrary and capricious standard in terms of actual application and use of resources.⁽¹²³⁵⁾ In determining whether the U.S. trustee acted arbitrarily and capriciously, the court could hardly avoid reviewing all the facts and circumstances.

Another concern is the potential for delay and increased costs inherent in any opportunity for judicial review. Even a specious motion might result in increased costs and could hinder the progress of a case unless the court addressed such a motion quickly and definitively. An adequately represented creditor arguably could use the threat of bringing a motion in court to increase its negotiating leverage. To this end, some commentators have suggested that a debtor should not be able to appeal the composition of a committee selected by the United States trustee because the debtor might have only strategic goals in mind.⁽¹²³⁶⁾ For example, a debtor might challenge an adverse decision and request an extension of the exclusivity period on the basis that the debtor does not have a suitably selected creditors' committee with which it can seriously negotiate a plan. The Commission opted not to limit a debtor's ability to raise issues regarding the composition of committees, reasoning that the debtor may have legitimate reasons to seek review of creditors' committee appointments, and courts would be able to recognize instances in which review was sought for illegitimate reasons.⁽¹²³⁷⁾

Others might be concerned about the policy implications of reestablishing court influence over appointments through the proposed review powers. However, the threat of any ethical dilemmas would be constrained by the continuing involvement of the U.S. trustee in the process. Although courts would have the power to review, they would remain removed from the actual appointment process.

2.4.9 Employee Participation in Bankruptcy Cases

[Comments by Commissioner Babette Ceccotti]

Given the well-established purpose of Chapter 11 to preserve jobs, participation by employees and their representatives in the reorganization process should be accepted and encouraged. Instead, representatives of employees and retirees and employee benefit funds have faced impediments to active participation in bankruptcy cases despite their recognized status as creditors and parties in interest. These obstacles take many forms, such as a lack of notice of a bankruptcy filing, failure to include debts owed to employees and benefit funds on the debtor's schedules and skepticism by the U.S. Trustee's office in the creditors' committee appointment process regarding claims held by unions or benefit funds. Employees not represented by a labor organization face additional obstacles due to the lack of collective representation. Because reorganizations typically involve significant business decisions affecting employees, the bankruptcy process should more readily accommodate participation by employees and their representatives.

Disclosure of Employment-Related Obligations

Notice and disclosure serve two important functions. First, better disclosure of potential liabilities and issues affecting employees and retirees contributes to a more complete view of the issues likely to arise in the bankruptcy and benefits all parties.⁽¹²³⁸⁾ Second, improved notice and more complete disclosure facilitate participation by employee representatives and employee benefit plans. This, in turn, enhances the prospects for a resolution of plan issues on a consensual basis.

One way to improve early and more thorough disclosure of employee-related obligations is amending the Official Bankruptcy Forms. As currently drafted, the Official Forms for the petition and schedules do not sufficiently prompt the preparers to include information about employment-related debts. The petition requires the business debtor to estimate the number of employees, but only for "statistical/administrative" purposes.⁽¹²³⁹⁾ Creditors holding unsecured claims entitled to priority and other unsecured claims are listed on Schedules E and F, respectively.⁽¹²⁴⁰⁾ Schedule E contains a list of the priority claims to be disclosed as they appear in Sections 507(a)(2) through (9) (e.g., "wages, salaries and commissions," as described in Section 507(a)(3)), and a category for "other"). However, common wage-related items such as arbitration and other awards for back pay, accrued but unpaid wages, vacation pay or sick leave in excess of the wage priority, severance pay, and claims arising under the Worker Adjustment and Retraining Notification ("WARN") Act are not referenced anywhere on the schedules, thus increasing the likelihood of omission. Nor are monies owed to employee benefit plans, beyond the amounts constituting priority claims under Section 507(a)(4), listed for disclosure. Thus, the debtor's initial court filings may not adequately reflect whether and to what extent employee interests may be affected by the bankruptcy case.

Additional instructions on the forms for disclosure of these obligations would assist the preparers in disclosing these debts.⁽¹²⁴¹⁾ In turn, the inclusion of this information would aid the U.S. Trustees in their initial investigations early after the filing of the case. Currently, without better information, the U.S. Trustee may have no reason to solicit information about debts owed to employees and employee benefit plans or related matters such as the likelihood of a company's withdrawal from a pension plan, an event which will give rise to a substantial claim.⁽¹²⁴²⁾

Committee Participation

One consequence of incomplete disclosure is that labor organizations and benefit funds are placed at a disadvantage in the committee appointment process. These entities are often omitted from the list of 20 largest creditors used for the appointment of creditors' committees,⁽¹²⁴³⁾ even though significant sums may be owed to benefit plans and to employees as of the filing date. Thus, unless the U.S. Trustees' offices seek out this information in connection with their initial investigations, it will be up to the employee representatives themselves--assuming timely notice of events--to make these obligations known and gain access to the process.⁽¹²⁴⁴⁾ Valuable time may be consumed early in the case with efforts to convince the U.S. Trustee that employment-related debts are in fact bona fide claims warranting employee representation.

The creditors' committee is the principal mechanism for collective participation in a Chapter 11 case. The courts have accepted the notion that labor unions and employee benefit plans are "creditors" eligible for membership, and that the inclusion of employee interests is entirely consistent with--if not required by--the diversity requirement of section 1102.⁽¹²⁴⁵⁾ The arguments typically raised in opposition to such participation have been repeatedly rejected: that unions and benefit funds are ineligible for participation because their claims are priority claims; that the union or the benefit fund may object to some element of the reorganization and should therefore be excluded, or that confidential information about the business cannot be shared with these parties.⁽¹²⁴⁶⁾ Nevertheless, employee representatives continue to face the same obstacles to committee participation.⁽¹²⁴⁷⁾

Changes in the materials promulgated by the U.S. Trustee program would improve the guidance available to U.S. Trustees about employee-related claims and reduce unnecessary disputes over participation. The Office of the U.S. Trustee Program Chapter 11 Policy Initiative (March 1993) regarding the appointment of committees contains no information about the kinds of claims held by employees, labor unions and employee benefit plans. Dissemination of basic information about the different kinds of employment-related claims, through the U.S. Trustee guidelines, would clarify issues repeatedly raised in the committee formation process and is consistent with the case law that has developed in this area.

The U.S. Trustee Program guidelines correctly note that unions are eligible for appointment as creditors. However, language suggesting an automatic exclusion where the union's claim is entitled to priority treatment pursuant to section 507(a)(3) and (4)⁽¹²⁴⁸⁾ fails to recognize that payment of priority claims may be but one dimension of a labor organization's or benefit fund's interests in a case. Creditors representing employee interests are intensely focused on the preservation of jobs, whether and to what extent wage and benefit modifications will be sought, and other business decisions that impact the employees, in addition to the payment of priority and other claims. Indeed, courts have cited the need for diversity and the distinct interests represented by these entities in granting them committee appointments.⁽¹²⁴⁹⁾ The courts have not allowed the presence of a priority claim to take precedence over the importance of these factors in ruling on appointment disputes.⁽¹²⁵⁰⁾ This is consistent with a recognition that committees are consensus-building vehicles that provide a forum to resolve diverse interests in a case.⁽¹²⁵¹⁾ This important function should eclipse technical disputes over whether the employees representatives' priority claims should disqualify them from committee participation. Facilitating participation fosters an inclusive process and promotes a consensual, rather than an adversarial, resolution of the reorganization.

Other Mechanisms for Participation

Official committees are the established means of collective creditor participation in the reorganization. Where employees are represented by a labor organization, or where there are benefit funds that pay employee health and other benefits, participation on official committees provides a voice for employment-related interests. While employees represented by a labor organization have access to the process through their representatives, there has been little opportunity for non-organized employees to participate. One emerging solution is the formation of a committee consisting of employees who are not represented by labor organizations to negotiate employee claim disputes with the debtor. In the recent Herman's Sporting Goods bankruptcy, an Official Employees' Committee was appointed for the purpose of representing non-union employees in respect of WARN and related claims asserted as a result of the termination of operations.⁽¹²⁵²⁾ The Bankruptcy Court ultimately approved a settlement of the claims negotiated by the committee on behalf of the non-union employees.⁽¹²⁵³⁾ Resolution of these claims through the committee allowed the employees and Herman's to avoid litigation over the claims.

The appointment of multiple creditors' committees is usually not favored.⁽¹²⁵⁴⁾ However, where there are issues common to a significant number of employees, and no other means of collective participation, the appointment of a committee to resolve such issues should not be hampered by the presumption against multiple committees. Indeed, the Bankruptcy Code already offers a model for representation of this kind in Section 1114, which provides for the appointment of a retiree committee where the debtor seeks to negotiate changes in retiree health benefits.⁽¹²⁵⁵⁾ As the Herman's experience demonstrates, the formation of an employees' committee to pursue specified issues with the debtor is preferable to costly, inefficient litigation and, therefore, should be encouraged.

Competing Considerations. It may be argued that a union or a benefit fund with only a claim entitled to priority cannot adequately represent other creditors holding only general unsecured claims, and therefore should be ineligible for appointment to a creditors' committee. The assumption is that a creditor with an unsecured claim entitled to priority will view the reorganization and claims recovery in a manner too dissimilar from those unsecured creditors whose claims are not entitled to a payment priority. For example, an unsecured creditor entitled to be among the first paid may more readily accept a liquidation alternative than a general unsecured creditor.

Concerns of this nature may be largely theoretical, however. As noted above, a labor organization or employee benefit fund evaluates a case in light of a variety of factors, not simply the payment of its pre-petition claims. Certainly, a labor union or benefit fund is unlikely to prefer a liquidation where there are jobs to preserve, even where its claim is wholly entitled to priority. Indeed, the fact that creditors may be motivated by multiple interests in a case is not a phenomenon limited to employee representatives. Creditors who are suppliers may be interested in the prospects for a continued business relationship with the debtor and therefore similarly adverse to a liquidation. Nor are enhanced payment opportunities limited to priority wage creditors. Commercial creditors may have alternative sources of payment or non-bankruptcy priorities.

Moreover, there may be too many uncertainties at the outset of a bankruptcy case to justify an automatic exclusion on the basis of a hypothetical, future payout. In any event, potential conflicts involving any creditor are legally insufficient grounds to disqualify creditors from committee membership.⁽¹²⁵⁶⁾ Indeed, such intercreditor conflicts are common among committee members.⁽¹²⁵⁷⁾ Potential conflicts are dealt with as part of the operating rules of the committee or through other means.⁽¹²⁵⁸⁾ The courts have been comfortable applying these rules to labor unions and funds and have rejected disqualification based upon potential conflicts, given the interests represented by these creditors.

The consequences of such a technical disqualification from committee membership, particularly on grounds that are unreliable predictors of a creditor's conduct, also should be given significant weight. The creditor's committee is the primary negotiating body for the formulation of a plan of reorganization and enjoys broad authority under the Bankruptcy Code. Disqualification for no other reason except that suggested by the U.S. Trustee guidelines would eliminate a distinct and significant interest from the only collective participatory vehicle in a Chapter 11 case. As summarized by the U.S. Court of Appeals in Altair Airlines "there is no reason why the voice of the collective bargaining representative should be the one claimant voice excluded from the performance of [the committee's] statutory role."⁽¹²⁵⁹⁾

2.4.10 Enhancing the Efficacy of Examiners and Limiting the Grounds for Appointment of Examiners in Chapter 11 Cases

Congress should amend section 327 to provide for the retention of professionals by examiners for cause under the same standards that govern the retention of other professionals.

The Bankruptcy Code provides for the appointment of examiners in certain Chapter 11 cases. Although they are not used in most cases, examiners perform critical investigatory functions when an independent and impartial inquiry is warranted. The fact that the Code explicitly contemplates the appointment of examiners further safeguards the integrity of the Chapter 11 process.

Because the primary role of an examiner is as investigator, examiners need to have the resources and tools at their disposal to carry out their responsibilities fully and competently. However, the Bankruptcy Code does not provide specific authorization for an examiner to retain professionals to assist in the performance of the examiner's duties. Some courts have permitted examiners to retain professionals under the bankruptcy judges' general all-writs power under section 105(a),⁽¹²⁶⁰⁾ but a specific and direct source of authority would be preferable.

The Commission therefore recommends that bankruptcy courts be authorized, but not required, to permit the retention of professionals for examiners when cause exists to do so. The retention would be governed by the same standards that currently govern the retention of all other professionals as would the entitlement of an examiner's professionals to compensation out of the estate. The need for professional assistance will depend on the duties of the examiner and the circumstances of the case. For example, if an accountant is appointed as an examiner solely to review a debtor's books and records, the accountant is unlikely to require the assistance of a professional. However, an examiner may need to retain professionals with specialized expertise upon the discovery of a particularly complex financial matter. In addition, if an examiner is not an attorney, the examiner may need to retain legal counsel upon uncovering a potential fraudulent conveyance or if parties in interest make allegations against the examiner personally.

Competing Consideration. A Chapter 11 case already involves many professionals, and some people might urge that the examiner's power to retain professionals not be expanded due to increased expense to the estate. However, once appointed, the examiner serves an important function helping to protect assets of the estate and investigating problems. The examiner should have the proper tools and appropriate professionals to fulfill this responsibility. In addition, the Commission has a corollary Recommendation to eliminate the requirement that examiners be automatically appointed without evidence of purpose in any case with more than $5,000,000 in unsecured debt (discussed in the following pages), lessening the likelihood that professional costs will be incurred unnecessarily.

The Advisory Committee on Bankruptcy Rules of the Judicial Conference should consider a recommendation that Federal Rule of Bankruptcy Procedure 2004(a) be amended to provide that "On motion of any party in interest or of an examiner appointed under Section 1104 of title 11, the court may order the examination of any entity."

The ability to acquire information under Rule 2004 of the Federal Rules of Bankruptcy Procedure, and to use other discovery tools, can be critical to investigating fraud and other misconduct or mismanagement, which are precisely the responsibilities of an examiner. While parties in interest can request a Rule 2004 examination, an examiner might not be a party in interest under section 1109 of the Bankruptcy Code.⁽¹²⁶¹⁾ No reported decision has been found denying use of Rule 2004 to an examiner,⁽¹²⁶²⁾ but there is little justification for leaving any ambiguity on the matter. This discovery tool should be available to all examiners in pursuing their investigatory functions. Thus, the Commission recommends that the Rules Committee of the Judicial Conference amend Rule 2004(a) to specifically include an examiner's right to request an examination.

The Bankruptcy Code clearly mandates the appointment of an examiner in certain circumstances: under section 1104(c) of the Bankruptcy Code, the court must order the appointment of an examiner if an independent investigation would serve the interests of parties in the bankruptcy case, especially in a situation that potentially involves fraud, dishonesty, incompetence, or misconduct in the debtor's management of the estate's affairs.⁽¹²⁶³⁾ This requirement is inherently sensible, casting the examiner in the role of independent inquirer to ensure the integrity of the bankruptcy system. However, section 1104(c) contains an additional provision: subsection (2) specifically requires the court to order the appointment of an examiner on the request of a party in interest, if the debtor's fixed, liquidated, unsecured debts to non-insiders, other than debts for goods, services, or taxes, exceed $5,000,000. This appointment is mandatory even if there is no suggestion of mismanagement or wrongdoing, and even if an investigation would impede the interests of creditors and other parties.

At best, the current provision duplicates the requirement to order the appointment of an examiner in the interests of the estate and the estate's creditors. Particularly in large Chapter 11 cases, creditors' committees and their professionals provide a check on management and serve routine investigative functions until a particular situation is suspected that justifies the appointment of an independent examiner.

Section 1104(c)(2) is not merely a benign duplication, however. Because it permits parties to seek the appointment of an examiner when there is no need for an examiner, it offers opportunity for mischief by a party in interest. Requests under this provision can be used as leverage and delay tactics by a few creditors seeking to serve their own interests rather than furthering the interests of the estate and the creditor body overall. A creditor who can threaten to demand an examiner without any showing of a legitimate purpose can enhance its own treatment in exchange for withdrawing its demand. Rather than helping to protect the estate, it more likely serves as a strategic tool to cause delay and to increase costs that decrease the funds available to distribute to creditors at large.

For these reasons, some courts observing misuse of the mandatory appointment provision have refused to appoint an examiner under this provision, using waiver or laches as a basis when a request is made late in the case.⁽¹²⁶⁴⁾ However, a literal reading of section 1104(c)(2) does not leave room for this discretion when the case involves $5,000,000 in fixed, unsecured debt.⁽¹²⁶⁵⁾

The Commission recommends the deletion of this arbitrarily-triggered provision. This change would eliminate a provision that easily could become a source of delay. The deletion of this provision will avoid the unnecessary costs of litigation over the question and the costs of hiring an examiner in circumstances not needing an independent investigation. The Commission heard only supportive statements regarding this Proposal to eliminate section 1104(c)(2). The consensus appears to be that section 1104(c)(2) is neither helpful nor necessary to preserve the authority of the court to order the appointment of an examiner in instances when the appointment would serve the interests of parties in the case.

Competing Considerations. Absent an automatic provision for the appointment of an examiner, public investors may not be able to afford to make a request for an examiner. In such cases, however, the Securities and Exchange Commission can take actions to protect their interests.

2.4.11 Valuation

A creditor's secured claim in personal property should be determined by the property's wholesale price.

A creditor's secured claim in real property should be determined by the property's fair market value, minus hypothetical costs of sale.

The need for statutory guidance on the valuation of collateral was a consistent theme throughout the Commission's hearings. Early versions of the Commission's work in the consumer bankruptcy area included a recommendation for a compromise valuation standard that would not entail a fact-intensive inquiry and could be determined readily without requiring extensive litigation. Once it became clear that the Supreme Court would speak directly to the issue of valuation in Associates Commercial Corp. v. Rash, the Commission deferred further consideration of the precise standard to be recommended. In June of 1997, the Supreme Court ruled that the relevant statutory provision, as it currently is written, entails a fact-intensive analysis. With the benefit of the Court's interpretation, the Commission decided to revisit the need for a statutory recommendation to lessen the fact intensive nature of the analysis. At the August 1997 meeting, the Commission discussed the Rash decision and concluded that a statutory amendment would be beneficial and directed that materials be prepared accordingly, which culminated in this recommendation.

The Bankruptcy Code currently does not define the appropriate method to determine "value" of collateral. Instead, the process for valuation is left to case-by-case determination. Section 506(a), which governs the determination of the allowed secured claim, states:

An allowed claim of a creditor secured by a lien on property in which the estate has an interest, or that is subject to setoff under section 553 of this title, is a secured claim to the extent of the value of such creditor's interest in the estate's interest in such property, or to the extent of the amount subject to setoff, as the case may be, and is an unsecured claim to the extent that the value of such creditor's interest or the amount so subject to setoff is less than the amount of such allowed claim. Such 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.

Due to the flexibility inherent in this provision, the amount of the allowed secured claim may differ depending on the type of bankruptcy case, the kind of property, and the proposed disposition of the collateral.⁽¹²⁶⁶⁾ Even in low-dollar-amount cases, therefore, there is no bright-line rule to give the parties quick, inexpensive answers to a valuation question. With the method for determination left completely undefined, courts have applied disparate methods to similar circumstances, yielding results ranging from the highest (e.g. retail) to the lowest (e.g., forced sale) possible valuations, with many options in between, including replacement cost, wholesale, and "midpoint" (the average of net resale proceeds and retail, a compromise method derived from Chapter 13 trustees).⁽¹²⁶⁷⁾ In attempting to resolve the confusion, circuit courts of appeals have tried to provide more definitive answers, but they too have differed over the proper standard for determining the allowed secured claim.⁽¹²⁶⁸⁾ The announced standards have not always been clear, evidenced by the fact that judges reach conflicting interpretations of the relevant court decisions.⁽¹²⁶⁹⁾

The United States Supreme Court released a much-awaited decision on this issue, Associates Commercial Corp. v. Rash.⁽¹²⁷⁰⁾ Rash was a Chapter 13 case involving a tractor truck used by the debtor in his freight hauling business. In an en banc opinion reversing the initial appellate rulin