Fact Sheet

& Staff








Submitted by
The Honorable Edith H. Jones

The assistance Professor Barry Adler
and Mr. J. Robert Fowler, Jr. is gratefully acknowledged.

Table of Contents




IV.   CLAIMS CLASSIFICATION (Commission Rec. 2.4.15   )

V.   POST-CONFIRMATION MODIFICATIONS (Commission Rec. 2.4.19   )

VI.   PRE-BANKRUPTCY WAIVERS (Commission Rec. 2.4.5   )


A.   Section 365, Interim Protection and Obligations of Nondebtor Parties (Commission Rec. 2.4.3   )

B.   Clarifying the Conditions for Sales Free and Clear of Liens and Interests (Commission Rec. 2.4.11   )

C.   Consensual Releases of Nondebtor Parties Through Bankruptcy (Commission Rec. 2.4.12   )

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Less than 24 hours remain until the October 8 deadline the Chairman has imposed for submitting the Commissions's report to the GPO, 12 days before it is due to Congress. We have not been furnished with a final copy of the report covering Chapter 11 issues or of the reporter's introduction thereto. We did not receive even a rough draft of the reporter's introduction until last Saturday morning, October 4.

The drafting process has been disorderly. Commissioners must struggle with nearly a thousand pages of draft and attempt to write dissents from an incomplete product. We have not had a fair chance to coordinate dissents or comments on the general Chapter 11 issues. Time has artificially been called, and all requests for extensions have been denied.

Disingenuously, the Report fails to acknowledge that several of the most important general Chapter 11 proposals, the subjects of this dissent, passed only by 5-4 votes. As with the 5-4 split on consumer issues, these 5-4 splits reflect deep philosophical and practical differences among the Commissioners. The Report does not explain to Congress the reasons for these serious differences, as it should have done. This dissent, written under an impossible deadline, hopes to illuminate the importance of what the Commission did -- and what it failed to do.

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Although the Reporter's Introduction and the General Chapter 11 proposals do not acknowledge it, there is serious debate in business and academic circles over the efficacy of American Chapter 11 reorganization law. (2777) The Commission's review of Chapter 11, dominated by bankruptcy professionals and academic defenders of Chapter 11, never engaged the debate, but Congress should know it exists.

Setting that larger debate aside due to the press of time, it is important to note that the Report acknowledges that transactional expenses, delay and legal uncertainty plague Chapter 11 of the Bankruptcy Code and should be reduced. Transactional expenses incurred for lawyers, accountants, appraisers and investment bankers do little to enhance the value of the reorganizing entity or the pot available for creditors. Delay imposes debilitating costs on the debtor and creditors. Legal uncertainty, rooted in the very structure of Chapter 11, is a significant source of both expense and delay. I contend, however, that the goal of reducing costs and inefficiency was not met at all in the proposals from which I dissent. In fact, the Commission did not vote or act upon proposals that would actually reduce cost and delay.

The whole point of the majority's proposals on absolute priority and classification is to shift bargaining power in favor of the debtor and to move from firm rules to a standardless approach that invites litigation over significant confirmation issues. Where there is more room for litigation, there will be more expense and delay in reorganizations. The impact of the post-confirmation modification and pre-bankruptcy waiver proposals will be similar: those proposals are not only vague, they create a vast reservoir of new rights for debtors, inviting debtors to exercise leverage over creditors that has little to do with the business issues with which reorganization should be preoccupied. Finally, the recommendation to provide interim protection for non-debtor parties before the assumption or rejection of an executory contract explicitly refuses to adopt the most obvious standard of compensation: the contract rate. Costs and delay are not reduced by this proposal's reference to legal nostrums such as "restitution principles," especially where, as here, the non-debtor party is forced to go to court to get its rights recognized.

On all these matters of great practical import in reorganization cases, the Commission majority chose against simplicity, clear rules, lower costs, and less litigation and in favor of Chapter 11 debtors over creditors. While making these explicit choices, however, the proposals from which I dissent consistently fail to explain their implicit assumptions. These assumptions include: debtors need the enhanced leverage and ability to litigate; there are too few confirmed plans, and these proposals are necessary to assure more confirmations; the debtor lacks sufficient control in Chapter 11; and the court, which must render decisions on these vague new standards, is a forum preferable to the marketplace. All these propositions underlie the majority's proposals, all are highly controversial, and none are justified in this Report.

There are other dogs that did not bark. An overarching feature of today's reorganization business is the proliferation of vulture investors, who buy distressed claims and stocks low and hope to sell out fast and high. Distressed debt buyers can participate in a Chapter 11 company's equity, subordinated debt, bank debt, or asset sales. The impact of such parties on these proposals should have been addressed by the Report. Perhaps, in fact, these proposals seek without saying so to mute the effect of vulture investors. One well-known debtor's lawyer worries: "[The vultures] don't care about fixing the [bankrupt] business. They say, 'Let the market take care of that' . . . . There's a greater emphasis on the purpose of Chapter 11 as a way not to rehabilitate businesses but to get creditors paid.'"(2778)

The final mysterious silence of the Report lies in its failure to discuss concrete proposals to get creditors paid more quickly and certainly. The Report does not refer to submissions by large trade organizations, including the National Housewares Manufacturers Association, the National Lumber & Building Material Dealers Association, and the National Food Manufacturers Credit Group, which represent thousands of American businesses and hundreds of thousands of employees. These groups are usually trade creditors, the most beleaguered class in bankruptcy. They sought reform of reclamation law and exclusivity periods, but they got nowhere with the Commission. Their interests are most seriously hurt by the delay, cost, and legal uncertainties in Chapter 11. Congress should listen to them.

The Report also neglects to deal with limits on exclusivity, plan mediators, incentives to efficiency built into attorney and professional fees, and other measures that would directly reduce cost and delay. Fortunately, however, on one occasion, the Commission was privileged to hear testimony from experts who grapple directly with proposals to reduce costs and delay. Because these experts' credentials entitle their views to serious consideration by Congress, I reproduce portions of their statements throughout this dissent.

1. Professor James J. White(2779)

In my view, it's wrong to think of a Chapter 11 as essentially a judicial proceeding. And the way I think of drawn-out Chapter 11s is to say they are like a beehive of activity in which each bee is trying to steal the wealth from somebody else who is also in the hive. And the longer we let it go on, the more likely it is that I, if I am a particularly aggressive and clever bee, will get somebody else's money.

It is my hypothesis, therefore, that the longer a Chapter 11 goes, the more reallocation of wealth that will occur, contrary to what Congress probably intended when it put down its priorities.

And secondly, that the larger the cost -- that is, in my view, the direct and indirect costs of Chapter 11 are more or less parallel to time. Many of the people in Chapter 11s charge by the hour or, in case of investment bankers, by the month. And the longer the hours and the longer the months, the larger the direct costs.

My hypothesis is: It is also true that the indirect costs will grow, because the business is not run well when it's under the supervision of a court and is subject to committees who are fighting one another. That leads, in my view, to bad decisions, wrong investments, and to the failure to make investments that probably should be made.

At least on the surface, a proposal for the reduction in the time and for the simplification of Chapter 11 should be noncontroversial. There is no one that I know of that publicly will speak in favor of delay, and there is no one that I know of who takes the position that a business has a right to linger for a long period in Chapter 11 in order to wait till the next upturn in the economy so that it might get healthy.

Privately, however, I suspect there are many of us who would like to see Chapter 11 as elaborate and complex and continued. I have charged Harvey Miller with that in print, and the way Harvey rose to the bait suggests to me that I was right.

. . .

So my view, I guess, is there are a certain number of people -- not excluding law professors, who like to teach complicated rules like this, and not excluding bankruptcy judges, who but for Chapter 11 would be condemned to live on an intellectual dung hill, I think.

One smart bankruptcy judge in the Midwest said to me -- I said, "What if Chapter 11 were appealed? What would you do?" He said, "I would resign."

. . .

But I suspect that even the bankruptcy judges are not completely objective about this. And even they would find it -- would have the kind of reaction that I instinctively have when somebody attacks tenure or the right to teach only three hours a week as opposed to 40, like I should, I suppose.

In any event, let me suggest -- my argument, I guess, basically is that we should change -- that you can't speed up Chapter 11s without changing the incentives of the parties to some extent.

And I have at least three proposals to change those incentives. These will not meet with wide acclaim necessarily; though these are only suggestions, and there are other things you could do that might have the same impact.

In other words, my argument to you is: Instead of saying, "Should we change this little section 1129," you ought to think about the question, "As an operational process, are there things we can do to it, maybe in Chapter 13 or Chapter 3, that will make the incentives different so that it will make people want to get done sooner?"

Let me give you three suggestions that I have. First, of course, is the possibility -- that will be suggested and elaborated on by Mr. Sigal -- of appointing a trustee. And there are a variety of other proposals that are around in different writing about trustees.

In my view, the virtue of a trustee is not that the trustee will run the business better than the existing management. The virtue of the trustee is that he is a threat to existing management. And if I, as the manager, know that I will be threatened before I -- when I go into bankruptcy or while I'm in bankruptcy, that may change my attitude and will change my behavior as a manager or as a debtor in possession. So I would second Mr. Sigal's suggestion for the appointment of a trustee.

Secondly, I would argue for a modification of section 507(b), maybe a modification of 507(a).

507(b) now says if I, as a secured creditor, ask for the stay to be lifted, I am denied and I am given adequate protection, and that protection proves to be inadequate, to the extent of the inadequacy I have a priority claim.

One might change that rule in a way I have suggested in the paper I will give you afterwards which would automatically give the secured creditor that right.

Now, the consequence of that, of course, is that there will be a large number of people who will be looking at secured creditors who will say, "If we drag this out and if we, in effect, take money out of the pockets of secured creditors, that will ultimately come out of our pockets, because they will rank above us in the distribution." And assuming there are enough assets to pay at least the priority creditors, that will change the motivation.

Now, I realize that Harvey and lots of other people will squeal like pigs stuck under a fence, because they will say, "Well, you'll never be able to hire a lawyer, you'll never be able to hire an accountant, unless you can assure that he will be paid."

I doubt that's true as an empirical matter. But even if it is true, you will be able to find some people, and the motivation for them is to get done quickly.

The third proposal I would make is to consider the reversal of section 361 -- or amendment of 361 to reverse that -- Timbers of Inwood(2780) -- which said that you do not get opportunity costs if you're a Chapter 11 -- or if you're a security creditor in Chapter 11. That, too, would have the same consequence.

And I would argue that the Supreme Court was not entirely true to the indubitable equivalence argument or language in section 361 when it did that.

I conclude with just two points. And I am sure there are more clever ways than I have suggested to modify Chapter 11 in order to increase the speed.

Let me conclude with two points. One: The Commission, in my view, should devote careful thought to the question, "How can Chapter 11s be made to go faster?" Everybody, at least publicly, acknowledges that would be important and desirable.

Second, I would argue that the speed of Chapter 11s will quicken only if you change the incentives of the players. It is not enough simply to change 1121 and say to a judge, "You've got to order -- end the exclusivity period in two months, or one month, or something like that."

So I endorse the possibility of shortening that period. But I think it better to modify things like section 507, like Timbers, or like setting up a trustee.

2. Dean Douglas Baird(2781) cautioned the Commission to reform bankruptcy law with clear rules rather than vague, open-ended tests to reduce costs and create uniformity:

I would just remind everyone of the first principle of legislative reform, which is part of the Hippocratic Oath, which is "First, do no harm."

Also, remember that in law, 95 percent is often perfection. The best is very frequently the [enemy of the good] . . .

. . . if you have unclear rules, you're going to have less uniformity. A judge in Chicago is going to treat things differently than a judge in Delaware or a judge in New York. That invites people picking different judges and different places on the base of the kind of treatment that receive.

[Next] . . . the less clear the rules, one thing that's more certain than anything else is the higher the cost of the bankruptcy. The less certain the rules, the more vague the standard, the more you have a seamless web that needs to be unraveled.

Now, obviously, with change, there's always going to be a little litigation, and that's okay. But unclear rules themselves, vague standards themselves are an opportunity for litigation, an opportunity for lawyers to write long briefs, an opportunity to have longer and more complicated discussions.

Vague rules lead to longer and more expensive bankruptcies, higher fees for lawyers. Not something that's in the interest of unpaid workers, tort victims, or nearly anyone else.

And my final concern is something that, again, I think is a little bit subtle. The impulse is to have bankruptcy judges do equity and to look out for people. And the more vague the rule and the less clear-cut and the more discretion the bankruptcy judge has over that domain, you might think the more compassionate we're going to be for the people who can't protect themselves.

I worry about exactly the opposite. If you have unclear rules, the people who are going to benefit the most from them are the most sophisticated parties with the most expensive lawyers. A world in which you have unclear rules, unclear priorities, unclear consequences in bankruptcy is a world in which there is an opportunity for people who can't protect themselves to be left with the short end of the stick.

And it's for all those reasons that I would urge both caution in bankruptcy reform and to be very careful about the consequences of bankruptcy reform, and to remember the success stories of the Reform Act and before then.

And I think the characteristics of the most successful bankruptcy reforms we've seen in the past have three basic characteristics: You have judges who are acting as judges, who are looking at the law and trying to resolve disputes in the context of an adversarial system.

Secondly, you have judges who are willing to take advantage of market mechanisms when they're available. They're not always available. But if market mechanisms are available and judges aggressively seek them out, it turns out that those have been very successful since 1978.

And finally, bankruptcy judges, like every other official, have to witness the temptation to be a social engineer. We simply don't know enough to entrust in anyone -- and especially a judge who can't be immersed in the facts and can't be cozy with the facts and the business -- we can't entrust in anyone the job of being a social engineer. Everything we've learned about markets and how markets work tells us that that's a big mistake.

And when you combine those things together, I think it suggests that the Commission, in a number of the ways it has looked at Chapter 11 cases, should be extremely cautious.

3. Mr. Mike Sigal(2782) recommended the appointment of a plan mediator after a certain period in the litigation process to bring the parties seriously and definitively to the bargaining table:

As a backdrop, let me say that I think it's undeniable that bankruptcy reorganization legislation is an integral component of the capital market system. It permits a private-sector solution to economic distress, whereas in many other parts of the world you end up with a public-sector solution.

On the other hand, I think our system that we have today takes too long, costs too much. And I don't think it really has the confidence of the American public, and that's an important ingredient of how this government works.

I don't think that -- I think we need something that balances both the need to have bankruptcy reorganization in appropriate cases that preserves jobs and that maintains certain values, at the same time without bringing in negatives of it taking too long, costing too much, and adversely affecting this country's great strength, which is its capital-raising ability in both the capital and private credit markets.

. . .

[My proposal is] this: The debtor in possession would have a defined period of time -- maybe longer than the four months that now exists, maybe six months -- to file a plan of reorganization. After that time, any creditor or other party in interest could file a plan of reorganization.

If a reorganization was not confirmed within some other defined period of time that the Commission would choose -- say a year -- the court would appoint a plan mediator.

Now, the plan mediator would not be a traditional trustee. The plan mediator would not run the business. The debtor in possession would stay in place and run the business. The plan mediator's sole focus should be the reorganization plan. The plan mediator would be a neutral, would have no economic interest in the outcome.

And I think that lots of -- today, I think there are quite a lot of people that would create a pool from which plan mediators would come from. These would include restructuring professionals, retired judges and attorneys, law professors, and even practicing attorneys.

The goal is to achieve a consensual resolution among the parties. But in order to prevent parties from stonewalling the mediation process, the plan mediator would have the power to ultimately propose a reorganization plan or to report to the court that he or she didn't believe a reorganization plan was possible.

I would not suggest a plan mediator if there had already been a Chapter 11 trustee appointed, which is already in neutral. And I would give the court some discretion not to have a plan mediator if a reorganization was on the verge of being confirmed or if there was some other compelling reason not to appoint a plan mediator.

. . .

And in my view, having a plan mediator appointed will have two impacts. One is: The fact that it's out there will force people to take it very seriously; that if they want to do it themselves, they have to do it themselves within a reasonable time that the Commission would determine.

And secondly, if they don't do it themselves, then what you would have is, instead of the litigation that happens in court now about whether there should be exclusivity or extended and all that stuff, you would simply permit parties to do a financial restructuring, a business restructuring with the aid of a neutral that has some experience in the area. And it may well be business experience as opposed to legal experience, while at the same time you've got the aura of the Federal Court in the background.

This Commission could have had an invigorating debate over proposals made by Professor White, Mr. Sigal and the other experts quoted herein. Unfortunately, the opportunity was lost.

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Richard Breeden(2783), Former Chairman of the Securities Exchange Commission, spoke at a May 1997 NBRC forum in Washington, D.C. and eloquently explained the larger financial context in which the absolute priority rule plays a key role:

[W]hen one starts tinkering with [the absolute priority concept], you should know that in capital market terms, you are tinkering with a live nuclear bomb.

And I say that because there are approximately $16 trillion today invested, trading all day long today in the American economy, in securities predicated on calculations of the tradeoff between risk and return.

And to the extent that we alter in ways that are ambiguous, subjective, imprecise, and unpredictable the way in which capital will be handled in the event of an insolvency, you are at risk of changing those calculations of risk and reward and people's ability to make an accurate projection early on in the game, which is a predicate for their actual investment.

. . .

So this risk-and-reward calculus is absolutely critical to the formation of technology and the formation of young companies.

We have come a long way. We have today a greater ability to calculate risk and to model it, the methodologies, through derivatives. And the option-pricing models that have come along out of our trading markets have given us a better ability to quantify risk than ever before, up to the point of insolvency.

And that is where I think we have a weakness, an inability to then make accurate predictions of how capital will be handled and how the relative priorities set forth in contracts -- in securities, which are nothing more than contracts, of course -- will, in fact, be handled by the courts.

. . .

And I'll end on what I think the result would be. Capital markets are very, very rational. You can't always understand everything. Not all information is available. It isn't always reliable.

When information or the ability to analyze risk isn't certain, it doesn't mean that there will be no investment, but the market will take a discount. If the market isn't sure about something, it will just say, "Well, I might be willing to lend 95 percent against that portfolio of assets in a normal circumstance. But because I have some uncertainty, I'm only going to be willing to lend 70 percent instead."

. . .

So markets, when faced with uncertainty, immediately, immutably, always start discounting. And that discount is a discount that isn't just applied in the case of statutes that apply to all companies in the economy. The discount isn't just applied to the people who are insolvent.

The discount, in capital terms, will get applied to the new companies that aren't yet created, to the live companies that aren't going to go insolvent but might, because no one knows who will.

And therefore, the cost of capital and the availability of capital to companies throughout the economy will change. That cost of capital will rise. And for the smallest, most difficult-to-finance companies, the job of finding capital will be that much harder.

So one has to be terribly careful that in trying to make it possible for people like me to come in and rehabilitate companies -- and I'm trying to save 150 jobs in Syracuse, New York, which is not blessed with the world's highest rate of job growth -- it is important to have some tools to be able to try to fix companies where they're fixable. I happen to believe that is socially important.

But at the same time, you have to do that in a way that protects the capital market's expectations and protects creditors. Or else I wouldn't have a chance to raise money for our future growth, and people like me or people who are simply entrepreneurs trying to create other companies wouldn't be able to do so because of too much risk.

The absolute priority rule represents the Bankruptcy Code's respect for contractual rights created by mutual consent. The rule ensures that a firm can not thwart state law priorities by retaining an interest in the reorganized firm over the objection of an impaired class of creditors. This expectation that contractual rights will be respected, even in insolvency, is critical to the availability of capital, particularly to the new ventures that drive the American economy. The five-member Commission proposal ignores the macroeconomic effects described by former Chairman Breeden.

The majority's proposal codifies a new value exception to the absolute priority rule in exchange for lifting the debtor's exclusive right to propose a plan when the debtor moves to confirm a new value plan. Although the existing uncertainty about the survival of the new value exception under the Code needs to be eliminated, the majority is not correct in reasoning that "[a]ny recommendation made by the Commission that would settle the long-debated question on the new value exception would benefit the collective negotiation process." The majority's proposal would not have a salutary effect on Chapter 11 cases, but would lead to more delay in Chapter 11, increase the ability of old equity to extort value from creditors, and leave intact or even exacerbate much of the uncertainty about the scope of the new value exception.

First, we should not codify a new value exception to the absolute priority rule: a debtor should not be able to force creditors to accept a plan that violates state law priorities. Second, the majority's proposal to codify a new value exception will not eliminate, and in fact may worsen, many of the problems it attempts to address.

1. There Should be no New Value Exception to Absolute Priority.

If there is real going concern value in a business, and that value can only be maintained if old equity keeps an interest in the reorganized firm, then there is no reason why creditors and equity will not come to a reasonable, negotiated agreement which allows both equity and creditors to share the going concern value. The absolute priority rule ensures that creditors do not have to accept equity's continued participation unless creditors decide that the contribution from old equity is needed and is at the right price.

Equity has an incentive to shade the facts in its favor: if it proposes a new value plan, equity will have an incentive to undervalue the firm and overvalue its own contribution. Conversely, if the plan purports to satisfy all claims, equity has an incentive to overvalue the firm. A hard and fast absolute priority rule is necessary to give equity the proper incentive to disclose information and make a realistic assessment of the firm's value. Without the absolute priority rule, equity's incentives to make full disclosure are reduced, except perhaps as is necessary to co-opt a class of creditors for cram-down purposes. Plus, bankruptcy judges, who are ill-equipped to value the reorganized entity and equity's contribution to it, are then placed in the position of making decisions that should be left to creditors. (2784)

Obviously, there is no reason to cut off the firm's equity as a source of new capital contributions to the firm. The absolute priority rule does not do this: if creditors believe the firm is more valuable with equity's participation than without, they are free to accept a violation of the absolute priority rule to allow this. In fact, equity often participates even though creditors are not paid in full. (2785) This may be because equity brings value to the firm or it may be because procedural advantages already in the Code necessitate that equity be "bought off" in order to get a reorganization plan proposed. (2786) Regardless of the reason, there should be little doubt that if old equity offers true value, the parties can reach an agreement for its participation. However, creditors, who would be free to reject equity's participation outside of bankruptcy, should make the decision, not a bankruptcy judge.

The presence of the exception replaces the negotiation-based solution fostered by the absolute priority rule with a litigation-based solution and its accompanying delay, expense and uncertainty. Not only does the very existence of the exception increase the leverage of the debtor to force creditors to take a deal they would not otherwise take, but the resort to litigation siphons value away from the reorganizing entity and to bankruptcy lawyers.

Furthermore, even considering only those courts which believe that the new value exception survives in the Code, few of the new value plans that have been proposed have been confirmed. (2787) Debtors fail more often than they succeed with respect to each of the five requirements from Case v. Los Angeles Lumber. (2788) Further, the majority of filed new value plans are in single-asset real estate cases where the benefits of reorganization under Chapter 11 are the most attenuated. (2789) Thus, the new value exception has promoted additional litigation and cost without significant confirmations of new value plans. Whether the five-member majority proposal will change this situation is anyone's guess.

The delay, expense and uncertainty created by codifying a new value exception will have negative consequences for the availability of capital. The uncertainty created by the debtor's increased power to force creditors to take a deal they would not otherwise take will cause the capital market to discount the expected returns from a particular extension of credit. This means that capital will cost more, and all business, especially small, startup ventures that provide the bulk of job creation in this country, will be hurt. (2790) This proposal may benefit the debtor once in bankruptcy, but, ex ante, all businesses suffer.

2. In Codifying a New Value Exception, the Majority's Proposal is Deficient.

The majority's proposal as it exists has serious shortcomings: (i) the proposal leaves untouched, and may even magnify, major sources of uncertainty in the new value exception; (ii) the supposed safeguard for creditors is illusory and will cause additional delay and expense, and (iii) the proposal will undermine the Commission's small business proposal by holding out false hope for failing businesses.

i. Uncertainty

As an initial matter, the proposed amendment does not explicitly include the five requirements laid down in Case v. Los Angeles Lumber -- new, money or money's worth, substantial, necessary, and reasonably equivalent. Although the majority explanation of the proposal may mean that the Los Angeles Lumber factors are intended to be retained, it is dangerous not to state that intention explicitly in the proposal rather than expecting courts to turn to the legislative history to reach this conclusion. A court might read the plain language of this proposed reform and conclude that the change both overrules the requirements of Los Angeles Lumber and overturns Northwest Bank Worthington v. Ahlers. (2791) This is not an idle fear: Freddie Mac(2792) and a prominent debtor's lawyer(2793) have already suggested that this proposal overrules Los Angeles Lumber.

Furthermore, even if the requirements are included in the code, each of the requirements has engendered significant litigation and their meaning is far from certain. (2794) There is no attempt in the proposal to reduce this uncertainty by clarifying what any of the requirements means. The proposal doesn't even define who "old equity" is, in this era of claims-trading! The increased uncertainty regarding whether the five requirements still exist at all will further increase the cost of bankruptcy and, accordingly, the cost of capital.

ii. Removal of Exclusivity

Mr. Hugh Ray(2795) questioned the effectiveness of the majority proposal to limit exclusivity when a debtor moves to confirm a new value plan:

The proposal purports to level the playing field by allowing competing plans.

It has been my experience in 30 years of doing this sole stuff that since competing plans have been allowed, that really isn't a meaningful remedy for creditors. The simple reason is that in cases where I have been successful in 1121 motions, in getting exclusivity lifted, the judges in some cases have refused to allow me to solicit or, in some cases, distribute a creditor's plans. So being allowed to file was not enough.

And even in cases where you can distribute a plan, usually the only meaningful plan that a creditor can file is a liquidation plan, which is not what a creditor wants to do.

The creditors do not have the access to information without signing a confidentiality agreement with the debtor. That agreement, of necessity, will usually prohibit -- because it's called a "confidentiality agreement" -- the disclosure of the debtor's operating activities to other potential bidders.

Usually the best bidder is a competitor, and certainly we don't want that person to know what their operating results are and how they operate. So when you give a creditor the right to file a competing plan, usually you've given very little.

The other problem is that when you look at competing plans, they often cause quite a mess. And the judges simply don't want to fool with them. And it has been my experience that almost all of them don't want to fool with them and it's something that they hate to see, because, again, usually one of the competing plans is a liquidation plan. So I don't think this is a meaningful relief for the creditors.

Under the majority's proposal, exclusivity is not lifted until the debtor moves to confirm a non-consensual, new value plan. Without further development, this is not meaningful protection for creditors. First, why wait until the debtor attempts to cram down the plan, i.e., after a creditor class has rejected the plan, before lifting exclusivity? Developing a competing plan takes time, especially in complex cases. The longer we wait to lift exclusivity, the longer the market forces on which the proposal relies to keep the debtor in check are kept at bay. Furthermore, the debtor has the information needed to develop alternative plans. Either exclusivity must be lifted earlier, e.g., when the debtor files a new value plan, or the information necessary to develop competing plans must be made available earlier. (2796) Otherwise, once exclusivity is lifted, the process must be delayed to allow creditors to obtain information and develop an alternative plan, causing more delay, expense, and lawyers' fees, or the ability to propose alternative plans will provide no meaningful protections for creditors. (2797)

The proposal also provides no protection to creditors from false solvency claims. If a debtor proposes a plan that allows equity to participate but purports to satisfy all creditors' claims, exclusivity would not be lifted under the proposal. A creditor who doubts the debtor's valuation of the firm would not be allowed to propose an alternative plan until the debtor's plan ran its course, perhaps with much of the firm's value. (2798)

There are other limitations on the ability of competing plans to provide meaningful assistance to creditors. Due to the limitations on solicitation, creditors voting on the debtor's plan may not be aware of the possibility that another party plans to propose an alternative. (2799) In addition, there may be parties willing to propose a plan who are not creditors, but the proposal appears to make no provision for allowing them to participate. (2800) Furthermore, removal of exclusivity may prove particularly worthless in small Chapter 11 cases by placing undue burdens on unsecured creditors who are already marginalized in such cases. (2801)

iii. The majority proposal undercuts the Commission's Small Business Proposal.

The Commission's Small Business Proposal repeatedly expressed the desire to retain the absolute priority rule. Whether that desire was retained, I have not had time to figure out. But it is obvious that this new value proposal deliberately intends to affect small businesses. It boasts of this result. By emphasizing the importance of "old equity" in small, closely held businesses, the proposal may well doom Ahlers.

This proposal should not apply to businesses covered by the Small Business Proposal for two reasons. Principally, it affords a backdrop against which a debtor can always threaten to attempt to confirm a plan within the 150-day limit of that proposal and thus cause creditors to compromise unfavorably to their priority positions to save the high costs of a contested confirmation. Alternatively, the debtor can use a "new-value plan" as an excuse to continue in Chapter 11 beyond the 150-day deadline. Second, as Judge Carlson's memo demonstrates, cramdown plans in small business Chapter 11's nearly always failed in the past. See supra, n.20. This proposal may represent a triumph of hope over experience. In any event, it foreordains the sort of manipulation that must be avoided if the Small Business Proposal is to accomplish its purpose.

3. Conclusion

Removal of exclusivity is an inadequate protection, and even at its best will only increase the time required to confirm a plan. Increasing the time in Chapter 11 becomes a strategic advantage for the debtor, allowing it to extract more from creditors, and a benefit to lawyers and other bankruptcy professionals. This impact could be devastating to the Commission's Small Business Proposal.

Although codifying a new value exception eliminates uncertainty about the existence of the exception, it leaves significant uncertainty regarding the requirements for and scope of the exception. Codifying a new value exception adds to the debtor's power, increases costs and litigation, and enriches bankruptcy attorneys. The supposed safeguard of lifting exclusivity when the debtor moves to confirm a new value plan does not provide real protection to creditors and benefits the debtor and bankruptcy attorneys.

Although the proposal may benefit the debtor once in bankruptcy, it has the unmistakable effect of raising the cost of capital. As Dean Baird reminded the Commission, we must remember the "first principle of legislative reform," borrowed from the Hippocratic Oath, "which is 'First, do no harm.'"(2802) It makes no sense to adopt this proposal, especially when a simple rule disallowing new value plans over creditors' objections could reduce reliance on judicial valuations and provide the certainty necessary to maintain a lower cost of capital.

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IV.   CLASSIFICATION OF CLAIMS (Commission Rec. 2.4.15   )

The majority proposes to amend § 1122 of the Bankruptcy Code to permit classifying similar claims in different classes -- and to treat them differently under an ensuing plan of reorganization -- if there is a "rational business or financial justification" for doing so. The proposal is justified on three bases. First, it is said to clarify current inconsistent caselaw. Second, the proposal is said to afford flexibility to a debtor to deal with a supplier or other creditor whose services are critical to reorganization, allowing the debtor more efficiently to focus on business needs during reorganization. Third, the proposal claims to enhance the prospects of successful reorganization by facilitating plans without, however, permitting gerrymandering of classes simply to obtain votes and to satisfy § 1129(a)(10). (2803)

This proposal should be rejected. For reasons explained below, it meets none of its stated objectives. Rather than clarify the standard for claims classification, it creates additional legal and practical uncertainty concerning the determination of what are "rational business or financial justifications." The flexibility sought to be conferred on the debtor is likely to become a straitjacket, as competing creditors exploit the debtor's newfound "flexibility" with pressure to improve their positions. Finally, to the extent the proposal substitutes a rule of equal treatment of similarly situated claims for case-by-case unequal treatment, it inspires yet another source of bargaining, maneuvering and litigation in an already intricate plan process and must delay rather than speed up the reorganization effort. The proposal, fundamentally antithetical to state law requirements of equal treatment for similarly situated creditors, effectively creates a new, ad hoc priority scheme, sacrificing certainty and predictability for the debtor's short-term objective of confirming a plan. The proposal overlooks, however, that its disruption of contractual expectations and state-law entitlements will have economic consequences beyond the reorganization world and will inspire contractual counter-measures by lenders and creditors and more conservative lending decisions.

1. The Proposal

The proposal permits differentiated treatment in bankruptcy of claims that outside it are legally similar. Such classification and separate treatment may occur without the agreement of the affected creditors. While other uses of the proposal are advanced, it also intends to permit a debtor to give preferential treatment to creditors, e.g.s., a supplier, landlord, employees, unions, who are perceived to be in a position to make credible threats to inflict loss on the debtor during or after reorganization. As Professor Picker has put it:

Instead of courts serving as a bulwark against these threats -- instead of the Bankruptcy Code operating as a commitment device that prevents the debtor from doing what it might otherwise have no desire to do -- debtors will routinely face pressure to give special treatment to particular groups of creditors.

In that regard, we can be confident about the consequences of this proposal. Interested parties will have every incentive to posture, to bluster, to suggest the harm that they can inflict, all in an effort to receive priority and distribution. We do not want to encourage this behavior. This is just about transferring wealth from one group of creditors to another. (2804)

It should be emphasized that under current law, creditors can voluntarily agree that a plan will prefer a group beyond its minimum Chapter 11 entitlement. It happens all the time. This proposal, however, paves the way for nonconsensual preferences.

2. Why the Justifications for the Proposal Fail

a. The Proposal Will Not Clarify the Law

One may readily concede that current interpretations of § 1122 are conflicting and inconsistent without, however, conceding the principle that creditors whose claims would be similarly situated at state law ought to be treated equally to each other in bankruptcy. (2805)

Unfortunately, the proposal will clearly lead to its own set of interpretational difficulties. What is a rational business or financial justification? May a debtor classify in separate classes claimants that it intends actually to treat the same under the plan, on the theory that each "class" deserves its separate voice in the plan? How compelling must a "rational business or financial justification" be if, for instance, alternative suppliers are available or employees' skills are fungible in the employment market? Can part or all of a "rational business justification" include the debtor's goal to confirm a plan? If so, where does one draw the line between this proposal and gerrymandering classes for confirmation?

Even more unfortunate, this group of questions will be added to the questions that already exist concerning classification! In order to afford separate treatment to similarly situated creditors under the proposal, there is an underlying assumption that but for the separate treatment, those creditors were otherwise entitled to equal treatment. The proposal, however, avowedly makes no effort to resolve current caselaw inconsistencies and determine what are "similarly situated" claims. Consequently, whenever a party objects to a differential classification, it must first persuade the court that the claims subject to this treatment were in fact "similarly situated" and then dispute whether there is a "rational business or financial justification" for distinguishing among the claims.

Rather than solve the current problems, this proposal blithely confounds them. (2806)

b. The Proposal Will Not Ultimately Afford a Debtor Increased Flexibility to Deal with Claims and to Concentrate More Closely on Business Aspects of Classification.

"Business flexibility" allegedly demands differential classification of otherwise similarly situated claims based on a "rational business or financial justification." The proposal lists hypothetical circumstances in which "flexibility" might be helpful, cases in which (a) bank debt will be treated separately from trade debt, (b) a "unique" supplier will be preferred over other suppliers, and (c) employee retirement contributions would be paid in cash ahead of commercial debt holders. (2807) The proposal also endorses the result in a recent case, in which employee claims for workers compensation were separately classified and paid in full, while identical claims, owed through subrogation to the company's workers compensation insurer, received much less favorable treatment. (2808)

Freddie Mac asked incredulously whether this Proposal would permit a court to classify separately a lender's deficiency claims and trade creditors' unsecured claims. (2809) Clearly it would.

Viewing the proposal in light of these examples, three questions arise. First, will business objectives be furthered by the classification flexibility accorded the debtor? Second, at what cost to the debtor's reorganization will the flexibility be purchased? Third, who will pay for the separate treatment of otherwise similarly situated claims? In my view, none of the answers to these questions favors the proposal.

First, the proposal and its rationale are somewhat schizophrenic. The proposal is expressed in extremely permissive language, as it allows separate treatment of similarly situated claims based simply on a "rational" business or financial justification. As every first-year law student knows, the "rational basis test" is one of the easiest for the proponent of a position to satisfy in all of American law. The proposal could have required "rational business necessity," "compelling business necessity," "compelling business justification," "objective business demands," or any number of more demanding formulations. That it did not suggests the broad discretion conferred on the debtor to discriminate among creditors.

At odds with the permissive language, the examples given to justify the proposal suggest some slight standard of business necessity. So the interpretive question arises, whether "rational" in this context will mean more than it does in other areas of law and if so, how much more. Just what is a rational business or financial justification, based on these examples? In how many cases can one really suppose that a particular supplier offers "unique" advantages to the debtor or that the labor market is so inflexible that a given pool of employees, who hold pre-petition claims against the debtor, will cling to their jobs throughout reorganization and be essential to the success of the reorganized company? Is there really a need for a debtor to discriminate between the residual unsecured claim of the bank and the unsecured trade claims, and if so, what is that need? On examination, the proposal's standard of "rational business or financial justification" is so amorphous as to offer a rubber-stamp to the debtor who chooses to discriminate among creditors. (2810) There will seldom be business objectives so pressing as to require separate treatment in the plan, but some rationalization can always be prepared under the proposal.

An equally unpalatable prospect is that the proposal will create business demands where none previously existed. As Professor Picker explained, supra, the proposal allows the debtor to cave in and offer special treatment to any creditor which is able to bludgeon, bluff and litigate its way to that treatment. In other words, the "flexibility" envisioned by the proposal is really an invitation to aggressive creditors to attack; creditors will be encouraged to make their special claims upon the debtor and to negotiate into favored treatment. (2811) In an environment where all formerly similarly situated claims may become unequal, we must presume that many creditors will exert pressure for preferential treatment from the debtor. The result will be opposite to that intended by the proposal: rather than going forward on the business aspects of reorganization, the debtor will become mired in haggling over the special claims of otherwise similarly situated creditors.

Allowing a debtor to discriminate between similarly situated claims imposes costs on the reorganization in two ways. First, as Professor Picker observed, it transfers wealth from the disfavored to the favored creditors. Second, it may cause the debtor to settle for more expensive terms in the reorganization plan than would otherwise be necessary. Buying peace with obstreperous creditors -- always a factor in Chapter 11 -- will be more costly as new groups of creditors, unshackled from their state law priorities, demand special treatment. The result may be a reorganized debtor burdened with heavier financial obligations. Both the debtor and its creditors will ultimately pay for the "flexibility" of classification based on rational business or financial justification.

Another way to look at the proposal is to ask why the decision to grant special treatment to claims should be removed from the affected creditors and placed in the hands of the debtor and courts. Nothing currently prevents creditors from voluntarily agreeing to accord special treatment to groups such as labor or suppliers where business necessity counsels such a course of action. Why should similarly situated creditors be forced to accept second-class status without their consent?

Finally, if a real notion of business necessity, as opposed to mere convenience and the short-term impulse to confirm a plan, underlies the proposal, why not implement the concept directly by providing preferred status to certain types of claims? For instance, the claims of labor unions or of essential suppliers or customers could be identified, much as small claims are currently identified for special treatment. (2812) The nebulous character of the proposal would thus be alleviated in favor of recognizing the groups most likely to benefit from it in practice. At the same time, collateral litigation by other creditors could be prevented.

3. The Proposal's Effects on Confirmation

No doubt the proposal is accurate in hypothesizing that, if the debtor is given free rein to classify similarly situated creditors differently, it will be easier to satisfy § 1129(a)(10) and confirm plans of reorganization. Confirmations will be achieved by diluting creditor consent, but there is no assurance that more confirmations will lead to more successful business rehabilitations.

The principle of creditor consent has long been an essential feature of reorganization and composition plans. Former Chapter XI permitted differential treatment of similarly situated claims, but it also required a plan to be approved by a majority vote in number and amount of each class. Chapter XI did not authorize cramdown, and it could not forcibly modify secured debt. The current Code diluted these consent provisions, albeit with a general rule of equal treatment for similarly situated creditors, by requiring a majority vote in amount of the claims in only one impaired class. Under the proposal, the requirement of creditor consent virtually vanishes, replaced by the debtor's unilateral ability to alter pre-existing claim entitlements by creating classes based on "rational business or financial justification." The proposal does not explain why creditor consent should be diluted again, when every plan of reorganization depends upon the creditors' continuing "investments" in the debtor. The proposal purports to decry "gerrymandering" of claims simply to confirm a plan over creditor opposition, but it imposes no real obstacle to that tactic.

To mitigate the impact of potentially unfair treatment of similarly situated creditors, the proposal assures us that ultimate plan confirmation must still conform to the "no unfair discrimination" rule. (2813) Shifting to the point of confirmation the determination of whether creditors in an otherwise equal class have been unfairly treated provides weak protection. First, although it is logically conceivable, it does not seem likely that a court which had earlier upheld a "rational business justification" for treating similarly situated creditors differently would later find that the plan "unfairly discriminates" against the treatment of those same creditors. (2814) Second, when a large case reaches the confirmation stage, there is tremendous pressure on the judge to confirm the reorganization plan and declare the process a success. If any facts or opinions can be adduced to suggest that payment of one group of creditors in cash is not unfairly preferential to another group of creditors, otherwise similarly situated, who are paid in promissory notes, the judge will be hard put to find unfair discrimination. This is particularly true where a long and torturous bargaining process, inevitable in big Chapter 11 cases, preceded the confirmation hearing.

Assuming that the proposal enhances the likelihood that plans will be confirmed, its proponents still bear a heavy burden to demonstrate why evading a necessity for creditor consent is acceptable. Perhaps the creditor skepticism accurately reflects the low probability of successful Chapter 11 rehabilitation. Under current reorganization law, the likelihood of successfully consummating a Chapter 11 plan, even in high-profile bankruptcies, is distressingly low. Many confirmed plans provide only for liquidation, while other debtors utilize repetitive Chapter 11 filings. It would seem reasonable to inquire why, under the proposal, when the approval of an even smaller number of creditors is obtained, the prospects for successful debtor rehabilitation will increase. Yet no attempt has been made to suggest that successful rehabilitations are now inhibited by the lack of cooperation between the debtors and critical suppliers or the failure to grant preferential compensation under plans. The proposal, in sum, is not justified or justifiable in terms of enhancing the likelihood that businesses will be successfully and fully rehabilitated under Chapter 11.

4. Impact of the Proposal on Chapter 11 and on the National Economy

As has just been noted, the proposal may fulfill its role of encouraging the confirmation of plans, but it does so in a vacuum, without considering the costs of the altered confirmation process or whether it will increase the number of successful business rehabilitations. Unfortunately, neither the costs nor the impact on the reorganization success rate favors adoption of the proposal.

The proposal has other adverse implications with respect to the ground rules of Chapter 11. First, because it tends to substitute negotiation and litigation for clear priority rules, it will foster disputes, delay and increased administrative costs in Chapter 11 cases. By contrast, a clear rule of equal treatment for similarly situated creditors would speed up the Chapter 11 process. Second, the proposal may reopen the old debate about paying creditors outside the plan, as it permits naked preferences to be granted within the plan. There is no principled reason to suggest that a creditor with leverage, e.g., a "unique supplier," deserves preferential treatment in the plan, while in the early stages of a case such more-than-equal treatment is not permissible. Similarly, the proposal essentially condones the granting of preferences in the bankruptcy plan, while § 547 prohibits pre-bankruptcy preferences, even though they may be motivated by dire business necessity. In summary, the proposal appears to aim for one goal: the confirmation of plans. The goal is achieved by sacrificing principles of equal treatment of similarly situated creditors; the superiority of rules to ambiguous standards; protecting a debtor from overbearing creditors; protecting the reorganization process from unnecessary transactional and administrative costs; and enforcing the requirements of consent to reorganization plans. It is not at all clear that the proposal furthers the goal of business rehabilitation.

From a larger perspective, the proposal must be viewed in light of general commercial law and the flexibility of our economy. It can easily be demonstrated that where lenders encounter increased uncertainty in the terms of recovering the value of their loans following default, two consequences will follow. Interest rates will rise and the terms of lending will become more onerous, or lenders will become skittish about lending to novel ventures. The proposal cites examples in which the unsecured claims of lenders or sureties, which otherwise hold equal status with other unsecured claims under state law, might be granted less favorable treatment because of creative classification decisions. The lessons of potential uncertainty are not lost on lenders, who must adjust their risk evaluations proportionately. Good loans will not be made to companies who could otherwise repay them. The economy will not profit from jobs that would otherwise be created and entrepreneurship that has been stifled.

Another consequence of the proposal is that if a class of creditors is subjected to uneven treatment in a number of cases, that class will probably urge Congress to pass corrective "special interest" legislation, further complicating bankruptcy law and the collateral economic picture.

Obvious conclusions are these: the proposal will not facilitate an increased number of business rehabilitations, whether or not it nominally increases the number of plan confirmations. By increasing the uncertainty of repayment in bankruptcy cases, it will have adverse macro-economic consequences on extensions of credit and will discourage good investments. If there is a serious need for preferential treatment of limited classes of creditors, those terms should be built into the law directly. Otherwise, a rule of equal treatment for creditors whose claims are similarly situated in state law or by the terms of federal bankruptcy law should prevail, unless the parties otherwise agree.

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The majority's proposal to allow modifications up to two years after confirmation will only increase the uncertainty associated with Chapter 11. While the proposal acknowledges that the extra two years "might lessen the perceived finality of the confirmation process," there is no doubt that the proposal will lessen the actual finality of plan confirmation and consummation: that is what the proposal is expressly designed to do. In effect, the proposal will mean that even in these few cases where a plan is confirmed and consummated, creditors are stuck in the Chapter 11 process for another two years.

It may be true that, in some cases, both the debtor and creditors would be better off if the plan could be modified post-consummation. If so, there is no reason that the parties can not provide for this in the plan itself by including mechanisms that lead to alternative outcomes based upon specified contingencies or that allow for the parties to modify the plan under certain conditions. Although I do not believe this is prohibited under the current Code,(2815) perhaps an amendment specifically allowing parties to provide a mechanism for plan alteration would be beneficial.

However, even if post-consummation modification might be beneficial in a few cases, it is a mistake to include an automatic two-year period for modifications. The primary purpose of limiting modification to the pre-consummation period was to ensure finality. (2816)

A debtor's creditors and interest-holders commit themselves to the governance of a particular mode of reorganization by acquiescing to confirmation of a plan, and by relying upon the terms and character of that plan in accepting it. Their rights under the plan then vest upon substantial consummation. The generalized public interest in finality in court determinations, and the Bankruptcy Court's specific interest in the integrity of its remedies, would both be prejudiced by allowing modification of a confirmed Chapter 11 plan when the parties' rights have been settled in such a fashion. (2817)

Creditors will discount their expected returns based on raising the cost of capital ex ante. In addition, the lack of assurance that a confirmed plan will be the final plan will make creditors less willing to agree to consensual plans. As the Ninth Circuit Bankruptcy Appellate Panel stated:

Congress drafted § 1127(b) to safeguard the finality of plan confirmation. If this were not the case, a proponent of a plan could file an endless series of motions to modify the plan, at every bump in the road, seriously jeopardizing the incentive for creditors to vote in favor of the plan. (2818)

The majority reasons that the proposal will be harmless because, although the "window of opportunity to modify" is widened, the proposal does "not otherwise liberalize the strict rules that define the parameters of permissible modifications. The "strict rules" referred to are the requirements of §§ 1122, 1123 and 1129--the same rules that governed the original plan confirmation. This defense admits the proposal's main flaw: a plan negotiated and confirmed as the "final" plan can be modified at any time for two years subject only to the same requirements that governed the original plan confirmation. In other words, there is no "final" plan until two years after confirmation.

As a result, this "proposal seems destined to increase litigation, not diminish it."(2819) Although the "substantial consummation" inquiry may become less important, all the highly litigated elements of plan formulation, solicitation, and confirmation can be revisited during the two-year period. As Professor Adler has opined:

Rare is the case where financial return is exactly what is expected. Equity holders may receive more or less than anticipated. Debt holders may be repaid or not, and even if repaid may earn a rate of interest better or worse than they might have demanded with the benefit of hindsight. Thus, it seems likely that within two years of confirmation someone will be unhappy with the terms of a plan and will have an incentive to go to court to modify. What is a court's charge? To continually adjust entitlements for two years as information or conditions change? This would be folly. (2820)

The majority also suggests that the proposal might stop some serial Chapter 11 filings. Even as articulated by the majority, this is not a powerful argument for the proposal. In exchange for a two-year period applicable to all debtors in which the debtor never really leaves Chapter 11, there is a slight possibility that some debtors who would otherwise refile might not if given the chance to modify the plan. This is not a good bargain.

Furthermore, it might be predicted that most modifications will not be to the creditors' benefit. Although creditors are likely to discount the returns expected under the plan because of the possibility of modification, the courts are not:

With the luxury of a two-year adjustment period, a court might confirm a plan that pays the obligations of creditors seemingly satisfactory obligations. If things go poorly in the first two years, however, the court might simply reduce those obligations on the request of the debtor, thus making the initial satisfaction merely illusory. (2821)

Just the threat of reopening the confirmation process to request a modification can give the debtor (or creditor if it is the plan proponent) substantial leverage.

Finally, the importance of the finality provided by § 1127(b) should be underscored. Consider the results of a recent study of Chapter 11 cases:

To begin with, the chances of a Chapter 11 case being confirmed are slim; only 17 percent even make it to confirmation. Of those that are confirmed, a quarter may be converted or dismissed for failure to comply with the plan. Out of the remaining survivors, 60 percent will ultimately yield consummated plans. And of these, approximately 25 percent will liquidate pursuant to their plans. Thus, the net end result is that out of all Chapter 11 cases filed, only 6.5 percent of these cases will culminate in a consummated plan and a rehabilitated debtor. (2822)

As a result of this proposal, even in those 6.5 percent of cases in which the debtor proposed a reorganization, confirmed a plan, and was able to substantially consummate the plan, the creditors are not out of the woods: the debtor has two years to propose modifications of the plan and, once again, subject all participants to another round of the Chapter 11 process. For the few cases that actually produce a confirmed and consummated plan, the Code should not render the effort meaningless.

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VI.   Unenforceability of Prebankruptcy Waivers of Bankruptcy Provisions (Commission Rec. 2.4.5   )

The Commission's proposal states that except as elsewhere provided in Title 11, neither contractual provisions nor even prior bankruptcy reorganization orders can waive or restrict "any rights or defenses provided by Title 11." There is one exception for issues resolved between the debtor and governmental units acting in their police or regulatory power.

A fundamental principle of bankruptcy law is that pre-existing contractual obligations should be preserved to the extent possible. The majority's proposal to nullify all pre-bankruptcy waivers throws this principle on its head, making evisceration of contracts in bankruptcy the rule, rather than the exception. Sophisticated parties should be able to contract for an alternative to the bankruptcy default rules. Even if some waivers should not be given effect, it is absurd to disregard mutually negotiated (and beneficial) waivers in many circumstances. The public would have been better served by a nuanced proposal to limit prebankrptcy waivers only in certain, clearly "bad" situations. The current proposal is breathtakingly vague.

As an initial matter, waivers should be presumed enforceable. The bankruptcy code is a set of default rules for dealing with the problem of financial distress,

[b]ut when the debtor and creditors have anticipated the possibility of a race among creditors, and either have solved it privately, or decided that the race is in their mutual best interest as compared to a costly bankruptcy process, the standard [collective action justification] for bankruptcy vanishes. Can anyone seriously contend that bankruptcy is better than an alternative for debtors and creditors who affirmatively choose the alternative?(2823)

Even acknowledging some of the problem waivers highlighted in the majority's proposal, there are numerous examples of waivers that are so clearly unobjectionable as to be beyond dispute. First, consider the asset-securitization industry, which now involves trillions of dollars in assets. (2824) Companies transfer their receivables and other rights to payment to a bankruptcy-remote entity, which issues debt secured by the receivables. The "bankruptcy remote vehicle" has no business other than holding and servicing the receivables purchased from the underlying company. As part of the transaction, various waivers of bankruptcy rights by the selling company are necessary to ensure that the payment stream from the receivables will not be interrupted. The standard justifications for the protections of bankruptcy are inapplicable to this situation.

The securitization of all types of financial assets increases the capital available for consumer loans and has lowered the cost of borrowing for consumers. However, uncertainty as to the consequences for these bankruptcy remote vehicles when the underlying businesses file for bankruptcy disrupts this market. (2825) The Commission staff was aware of this, and even received proposals to clarify that property transferred to asset-securitization devices were not part of the underlying businesses' estates. However, the proposal on pre-bankruptcy waivers not only does not address the concerns about current uncertainty surrounding these vehicles, but instead creates more uncertainty about the status of asset-securitization devices by casting doubt on any attempt to restrict the debtor's rights to be asserted in bankruptcy.

A second example involves waivers made as part of workout agreements that do not specifically refer to bankruptcy but could affect a debtor's "rights" once bankruptcy is filed. Some of the many types of provisions include extensions of loan maturity, the granting of new collateral, "springback" terms, arbitration clauses, and consent judgments. The proposal is unabashedly vague about what "similar provisions" it voids besides waiver of the automatic stay. In fact, it appears to directly threaten workouts by saying, "A bankruptcy court is free to consider the circumstances concerning a prior workout attempt . . . ."

Insincerely, the proposal denies that it might "alter the preclusive effect of judgments generally;" nothing in the proposal's language, besides its limited protection of governmental entities, so provides.

Perhaps the most common type of waiver is a waiver of the protections of the automatic stay. The debtor typically receives consideration in return for this concession, such as better financing terms or a specific benefit as part of a workout. (2826) In the reported cases, these agreements are negotiated where the debtor has a single asset or a non-operating pool of assets. (2827) Given the cost of bankruptcy and the low probability that there is any going concern value to preserve, these cases are sensible candidates for pre-bankruptcy waivers. Nonetheless, the proposal makes no provision for these circumstances, instead adopting a blanket rule disallowing all pre-bankruptcy waivers. This makes no sense, and the proposal makes no attempt to justify this rule in a single-asset or non-operating asset context. The debtor is once again given the hold-up power over the bankruptcy process despite the negotiated, mutually beneficial agreement otherwise.

The majority seems overly obsessed with preserving going concern value, regardless whether it exists in a given case. Rather than approach the problem of waivers that seriously threaten viable reorganizations directly, it eliminates all pre-bankruptcy waivers no matter how mutually beneficial. Several alternative approaches for dealing with undisclosed waivers have been suggested in the literature, but are not addressed by the majority. (2828)

Although giving a favorable nod in its written discussion to the competing policy of encouraging out-of-bankruptcy settlements and workouts, the proposal completely ignores that policy. Voluntary resolution of a firm's financial distress outside of bankruptcy often is cheaper and more efficient than proceeding through a lengthy Chapter 11 reorganization proceeding. Unfortunately, this proposal undercuts incentives for out-of-court workouts, because the parties have no assurance that virtually any agreement reached outside of bankruptcy will be respected in bankruptcy. (2829) The fact that a creditor must still litigate the enforceability of the waiver in the bankruptcy proceeding does not provide justification for eliminating any possibility of enforcement whatsoever. Indeed, perhaps that is an argument for clarifying circumstances in which waivers are enforceable. (2830)

This proposal seems to serve no one well except bankruptcy attorneys. No matter why or under what circumstances a waiver was negotiated, all bets are off in bankruptcy. The going concern value the majority is so anxious to preserve will be siphoned away by the increased delay in Chapter 11 and more protracted hearings on lifting the stay. This gives the bankruptcy attorneys new work and the debtor new power, but that power in bankruptcy will be offset by tougher credit terms for all businesses.

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A.   Section 365, Interim Protection and Obligations of Nondebtor Parties (Commission Rec. 2.4.3   )

B.   Clarifying the Conditions for Sales Free and Clear of Liens and Interests (Commission Rec. 2.4.11   )

C.   Consensual Releases of Nondebtor Parties Through Bankruptcy (Commission Rec. 2.4.12   )

The rapid approach of the artificial deadline for submission of this dissent prevents extended discussion of these proposals. A few words are in order, nevertheless, to explain why each of them needlessly increases costs and uncertainty, and why two of the proposals may expand bankruptcy jurisdiction beyond its constitutional limit.

The Commission recommendation 2.4.3    purports to clarify existing law by providing that the non-debtor party to an "executory contract" governed by section 365 is entitled to receive compensation until the debtor elects to assume or breach the contract. It is important to clarify the current mish-mash of law. The obvious clarification, however, would have been to apply the contract price to interim performance. The National Bankruptcy Conference so recommended in its Report, Reforming the Bankruptcy Code, at 214. The Commission's language is troublesome because, first, it requires a creditor to go to court to enforce its rights under this proposal, totally contrary to the self-executing rights that would be desirable. Second, its measure of damages, in which the contract price is "only one factor to be considered," is so vague as to be no improvement on existing law. (2831)

The proposal that would clarify conditions for sales free and clear of liens and interests, amending sections 363(f), is founded on an assumption that bankruptcy sales always yield superior value to liquidation sales. See Commission Rec. 2.4.11   . With due respect, this is an assumption that lacks proof in the Commission Record. Even more problematic, I question whether bankruptcy courts should be allowed to sell property in which the debtor's equity has been reduced to zero by the existence of unsatisfied liens. The remote possibility that reduction of the secured creditors' deficiency claims will affect distributions from the estate is not sufficient to create a reasonable nexus between the sale and the bankruptcy case.

Finally, I have a similar objection to the recommendation that would allow a plan proponent to solicit consensual releases of non-debtor parties through bankruptcy. Commission Rec. 2.4.12   . Section 524(e) seems quite explicit in currently prohibiting this result, regardless what some aberrant courts may have held. Section 524(e) makes obvious sense: bankruptcy should have nothing to do with liabilities of non-bankruptcy parties to their creditors. Authorizing the courts to permit such solicitations will undoubtedly complicate the plan process and give debtors yet another holdup incentive.



2777  THOMAS H. JACKSON, THE LOGIC AND LIMITS OF BANKRUPTCY LAW 209-24 (1986); Barry E. Adler, Financial and Political Theories of American Corporate Bankruptcy, 45 STAN. L. REV. 311 (1993); Barry E. Adler, Bankruptcy and Risk Allocation, 77 CORNELL L. REV. 439 (1992); Philippe Aghion et al., The Economics of Bankruptcy Reform, 8 J.L. ECON. & ORG. 523 (1992); Douglas G. Baird, Revisiting Auctions in Chapter 11, 36 J.L. Econ. 633 (1993); Douglas G. Baird, The Uneasy Case for Corporate Reorganizations, 15 J. LEGAL STUD. 127 (1986); Lucian A. Bebchuk, A New Approach to Corporate Reorganizations, 101 HARV. L. REV. 775 (1988); James W. Bowers, The Fantastic Wisconsylvania Zero-Bureaucratic-Cost School of Bankruptcy Theory: A Comment, 91 MICH. L. REV. 1773 (1993); James W. Bowers, Groping and Coping in the Shadow of Murphy's Law: Bankruptcy Theory and the Elementary Economics of Failure, 88 MICH. L. REV. 2097 (1990); Edith H. Jones, Chapter 11: A Death Penalty for Creditor Interests, 77 CORNELL L. REV. 1088 (1992); Robert K. Rasmussen, Debtor's Choice: A Menu Approach to Corporate Bankruptcy, 71 TEX. L. REV. 1 (1992); Mark J. Roe, Bankruptcy and Debt: A New Model for Corporate Reorganization, 83 COLUM. L. REV. 527 (1983); Lawrence A. Weiss & Karen H. Wruck; Information Problems, Conflicts of Interest and Asset Stripping: Chapter 11's Failure in the Case of Eastern Airlines, J. FIN. ECON.(forthcoming). Return to text

2778  Harvey Miller, quoted in Matthew Fleischer, A Healthy Economy Has the Bankruptcy Bar Scrambling for Work -- Except in Delaware, THE AMERICAN LAWYER, Apr. 1997, at 69. Return to text

2779  Robert A. Sullivan Professor of Law, University of Michigan School of Law; co-author of JAMES J. WHITE & ROBERT S. SUMMERS, UNIFORM COMMERCIAL CODE (4th ed. 1995). Return to text

2780  United Sav. Assoc. v. Timbers of Inwood Forest, 484 U.S. 365 (1988). Return to text

2781  Dean Douglas G. Baird, University of Chicago School of Law, co-author of BAIRD & JACKSON, CASES, PROBLEMS & MATERIALS ON BANKRUPTCY (2d ed. 1990). Return to text

2782  Meyer O. Sigal, Partner, Simpson, Thacher & Bartlett, Vice Chair, ABA Business Bankruptcy Committee. Return to text

2783  President and CEO, Richard C. Breeden & Co. Return to text

2784  As the Supreme Court has stated:

    The Court of Appeals may well have believed that petitioners or other unsecured creditors would be better off if respondents' reorganization plan was confirmed. But that determination is for the creditors to make in the manner specified by the Code. 11 U.S.C. § 1126(c). Here, the principal creditors entitled to vote in the class of unsecured creditors (i.e., petitioners) objected to the proposed reorganization. This was their prerogative under the Code, and courts applying the Code must effectuate their decision.

Northwest Bank Worthington v. Ahlers, 485 U.S. 197, 207 (1988). Return to text

2785  See Lawrence A. Weiss, Bankruptcy Resolution: Direct Costs and Violation of Priority Claims, 27 J. FIN. ECON. 285, 286 (1990); Lynn M. LoPucki & William C. Whitford, Bargaining over Equity's Share in the Bankruptcy Reorganization of Large, Publicly Held Companies, 139 U. PA. L. REV. 125 (1990). Return to text

2786  See Robert K. Rasmussen, Debtor's Choice: A Menu Approach to Corporate Bankruptcy, 71 TEX. L. REV. 51 (1992). Return to text

2787  See Memo of Bankruptcy Judge Tom Carlson to Edith Jones, dated November 7, 1996. Judge Carlson's memo indicates that only 20% of new-value plans were held to have met the Los Angeles Lumber requirements. Return to text

2788  308 U.S. 106 (1939). Return to text

2789  See Memo from Judge Carlson, supra, note 5 (60.3% of filed new value plans surveyed were single-asset cases). Return to text

2790  See Statement of Richard Breeden, Former Chairman of the Securities and Exchange Commission, NBRC Panel on Corporate/Small Business Bankruptcies, May 1997. Return to text

2791  485 U.S. 197 (1988). Return to text

2792  See Letter from Dean S. Cooper, Associate General Counsel of Freddie Mac, to Brady Williamson (June 3, 1997) ("The proposal as currently approved by the Commission does not [codify Los Angeles Lumber]"). Return to text

2793  Letter from Corinne Ball, Esq., to Panel Members for ABA Chapter 11 Subcommittee Spring Lunch Panel (Feb. 3, 1997) (enclosing overhead sheet listing criteria of Los Angeles Lumber as follows: "Necessity" -- no longer required; "Reasonably Equivalent Value" -- no longer required; What Happened to "Substantial" and "Money or Money's Worth?"). Return to text

2794  See Memo of Bankruptcy Judge Tom Carlson to Edith Jones, dated November 7, 1996 (noting that in proposed new value plans, "new" requirement was litigated in 46% of cases, "money's worth" in 36%, "substantial" in 43%, "reasonably equivalent" in 49%, and "necessary" in 35%). Return to text

2795  Partner, Andrews & Kurth, Immediate Past Chair of the Business Bankruptcy Committee of the ABA's Business Law Section; Member, Council of the ABA Business Law Section. Return to text

2796  The proposal makes no attempt to justify waiting so late to lift exclusivity, despite the fact that the problems associated with this delay and suggestions for earlier termination have been repeatedly brought to the attention of the Commission. See, e.g., Memo from Barry Adler to Professor Elizabeth Warren, dated August 12, 1996; Memo of Karen Cordry, NAAG Bankruptcy Counsel to Edith H. Jones, dated January 22, 1997; Statement of Hugh Ray, NBRC Panel on Corporate/Small Business Bankruptcies, dated May 1997; Statement of Certain Members of Ad Hoc Group of Secured Creditors, dated May 14, 1997. Return to text

2797  The presence of the new value exception, combined with exclusivity until the debtor moves to confirm a new value plan, also creates an incentive for equity to hold back on its best offer and low-ball the initial proposal. See Memo of Karen Cordry, National Association of Attorneys General Bankruptcy Counsel, dated January 22, 1997. For example, in the Celotex case, at least according to one participant (a creditor committee), the debtor insisted that its initial offer was the best it could make and obtained an opinion from an investment bank verifying that claim. However, the debtor's final proposal, made approximately 18 months later after exclusivity had been lifted, valued the company at twice the original proposal. See id. Return to text

2798  See Memo from Barry Adler to Elizabeth Warren, dated August 12, 1996 (proposing that exclusivity be lifted when the debtor files a "plan that provides for property to be received or retained by an entity other than (i) a holder of an allowed claim; or (ii) a holder of an interest with an allowed fixed liquidation preference or an allowed fixed redemption price"). Return to text

2799  Memo of Karen Cordry, NAAG Bankruptcy Counsel to Edith Jones, dated January 22, 1997 (citing In re Aspen Limousine Service, Inc. (Colorado Mountain Express, Inc. v. Aspen Limousine Service, Inc.), 198 B.R. 341 (D. Col. 1996)); Statement of Hugh Ray, NBRC Panel on Corporate/Small Business Bankruptcies, May 1997. Return to text

2800  Indeed, one would expect that those most capable of submitting competing plans would be parties other than a creditor, such as a competitor. See Statement of Hugh Ray, NBRC Panel on Corporate/Small Business Bankruptcies, May 1997. Return to text

2801  Many of these questions could be eliminated if creditors were allowed to credit-bid the value of their claims. If the claims held by creditors exceed the value of the firm's assets plus the proposed new value contribution, why should the creditors lose to equity's lower bid? Return to text

2802  Statement of Dean Douglas Baird, University of Chicago Law School, NBRC Panel on Corporate/Small Business Bankruptcies, May 1997. Return to text

2803  This provision requires the acceptance of one impaired class of creditors in order to confirm a plan. Return to text

2804  Professor Randal C. Picker, Designing Verifiability: Boyd's Implications for Modern Bankruptcy Law (draft paper presented to University of Pennsylvania Bankruptcy Conference 4/25/97). Return to text

2805  The proposal devotes many pages to describing these problems. I will not repeat or critique that analysis here. Return to text

2806  The Commission could have spent its resources more profitably by drafting language that will clarify existing caselaw, and for instance, articulate a firm rule of equal treatment and classification for claims that are similarly situated at state law. Return to text

2807  Peculiarly, the proposal lists as a separate example a case in which "small trade creditors" are treated preferentially because they cannot await repayment. This preference is already embodied in § 1122(b), so the example would appear superfluous unless the proposal intends to change this portion of § 1122. Return to text

2808  See In re Chateaugay Corp., 89 F.3d 942 (2nd Cir. 1996). Return to text

2809  Letter from Freddie Mac Associate General Counsel Dean S. Cooper to Brady Williamson (June 3, 1997). Return to text

2810  Because the rational business justification is open-ended, it is hard to see how it can prevent the gerrymandering of classes by means of artful classifications. Only a poorly-lawyered debtor would fail to conceive a rational business justification for preferring one group of creditors in a separate class. Return to text

2811  Beyond the scope of § 1122 but presenting similar overreaching problems, are the first-day orders in which secured creditors often obtain preferred treatment from debtors eager for post-petition financing. Return to text

2812  See fn.2 supra. Return to text

2813  See 11 U.S.C. § 1129(b)(1). Return to text

2814  But see In re Graphic Communications, 200 B.R. 143 (Bank. E.D. Mich. 1996). Return to text

2815  Section 1122(b)(6) allows the plan to "include any other appropriate provision not inconsistent with the applicable provisions of this title." Return to text

2816  See In re Charterhouse, Inc., 84 B.R. 147, 152 (Bankr. D. Minn. 1988). Return to text

2817  Id. (citations omitted). Return to text

2818  In re Antiquities of Nevada, Inc., 173 B.R. 926, 928 (B.A.P. 9th Cir. 1994) (citations omitted). Return to text

2819  Memo of Barry Adler to Edith H. Jones, dated July 15, 1997. Return to text

2820  Id. Return to text

2821  Id. Return to text

2822  Susan Jensen-Conklin, Do Confirmed Chapter 11 Plans Consummate? The Results of a Study and Analysis of the Law, 97 Com. L.J. 297, 329 (Fall 1992). Return to text

2823  Memo of Barry Adler to Edith Jones, dated July 15, 1997. I am grateful for Professor Adler's comments on this proposal. Return to text

2824  Memo from Martin Bienenstock to Elizabeth Warren on behalf of the Association of Financial Guaranty Insurers, dated February 19, 1997. Return to text

2825  Memo from Martin Bienenstock, supra, note 5. For example, when the Tenth Circuit concluded that a seller of accounts receivable retained a property interest in the accounts, thus subjecting the accounts to the automatic stay, the resulting legal uncertainty prevented effective assessment of asset-securitization devices by credit rating agencies. See id. (citing Steven L. Schwarcz, "Octagon Gas' Ruling Creates Turmoil for Commercial and Asset-Based Finance," NEW YORK LAW JOURNAL, August 4, 1993). Return to text

2826  See, e.g., In re Cheeks, 167 B.R. 817, 819 (Bankr. D.S.C. 1994):

    Perhaps the most compelling reason for enforcement of the forbearance agreement is to further the public policy in favor of encouraging out of court restructuring and settlements. ... In the instant case the Debtor received relief under the forbearance agreement approximating that which would have been available in a bankruptcy proceeding. The pending foreclosure sale was canceled, the foreclosure action was dismissed, and the Debtor gained an opportunity to start a new payment schedule which would prevent further action as long as she made the payments she agreed to make. To allow her now to receive the full benefits resulting from reimposition of the automatic stay as to [the mortgage] would be inconsistent with this Court's oft-stated skepticism regarding serial bankruptcy filings. Return to text

2827  See Robert K. Rasmussen and David A. Skeel, Jr., The Economic Analysis of Corporate Bankruptcy Law, 3 AM. BANKR. INST. L. REV. 85, 98 (1995). Return to text

2828  See, e.g., Barry E. Adler, Financial & Political Theories of American Corporate Bankruptcy, 45 STAN. L. REV. 311 (1993); Alan Schwartz, Contracting about Bankruptcy, 13 J.L. ECON. & ORG. 127 (1997); Rasmussen and Skeel, supra, note 6 (discussing filing system as means to inform other creditors of waiver agreements); Marshall E. Tracht, Contractual Bankruptcy Waivers: Reconciling Theory, Practice, and Law, 82 CORNELL L. REV. 301, 349-55 (1997) (proposing that waivers should be presumed effective, but subject to challenge on narrow grounds, e.g., that the secured creditor is reallocating value away from unsecured creditors, that the lender has taken advantage of an unsophisticated borrower, that there has been substantial change in circumstances since the waiver was executed, or that "extraordinary public interests" justify abrogating the waiver); Rafael Efrat, The Case For Limited Enforceability of a Pre-Petition Waiver of the Automatic Stay, 32 SAN DIEGO L. REV. 1133, 1155-65 (1995) (proposing that after creditor shows that waiver is "fair, freely entered into, and supported by consideration" and that the debtor has no equity in the property, then court would hold that the property is not necessary for an effective reorganization as a matter of law); Steven L. Schwarcz, Freedom to Contract About Bankruptcy, working draft submitted to Commission (Aug. 7, 1997). Return to text

2829  See letter from Honorable Paul Mannes, Bankruptcy Judge for the District of Maryland, on file with the Commission ("[T]here are numerous times where the parties enter into a thoroughly negotiated workout agreement where both make substantial concessions in an effort to avoid foreclosure. How many bites at the apple should the debtor get?"). Return to text

2830  See Tracht, supra, note 7, at 349-50. Return to text

2831  Section 365(d)(3) requires timely performance of all obligations arising under a non-residential real property lease until a decision is made by the debtor on assumption or rejection. The protection for landlords would appear to be plain in this provision, but according to one bankruptcy expert, even this level of clarity does not prevent litigation and manipulation. See Letter of September 22, 1997 from Preston T. Towber, Hirsch & Westheimer, to Edith H. Jones. The Commission's Proposal obviously does not remedy this type of problem; it doesn't even recognize it. Return to text

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