The Commissions Small Business Proposal Up or Out

The Commissions Small Business Proposal Up or Out

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The National Bankruptcy Review Commission has proposed a comprehensive scheme for reducing cost and delay in small chapter 11 cases. It provides mandatory fast-track treatment of all chapter 11 debtors with debts of $5 million or less. Many aspects of the small business proposal have received considerable attention, especially the $5 million debt limit, the statutory plan filing deadline and the simplification of the disclosure process.

Little attention, however, has been given to the proposed amendment of §1112, the most interesting and important aspect of the small business proposal. Section 1112 defines the circumstances in which a chapter 11 case is to be dismissed or converted to chapter 7 liquidation. The proposed amendments to §1112 provide a more effective means for early identification of chapter 11 cases with no genuine prospect for successful reorganization.

The Commission's report notes that only 15 percent of all chapter 11 cases result in a confirmed plan. In small cases, the confirmation rate is even lower. The principal reason for the low confirmation rate, according to witnesses who testified before the Commission, is that "the great majority of chapter 11 debtors lack any genuine prospect for reorganization." Of equal importance to the low confirmation rate is the fact that hopeless cases often remain in chapter 11 for a long time before they are dismissed or converted.

The Commission cites two valid concerns about undue delay in the dismissal or conversion of hopeless chapter 11 cases. First, in some of these cases there are unencumbered assets available to pay creditors that will be absorbed by post-petition losses and chapter 11 professional fees, if the case is allowed to remain in chapter 11. Second, and more important, undue delay in removing hopeless cases undermines the legitimacy of chapter 11. A chapter 11 debtor is afforded privileges unique in American law. In any other setting, a party seeking injunctive relief must establish a likelihood of prevailing on the merits. In contrast, a chapter 11 debtor is afforded the broadest injunction known in American law without any showing and without losing control of its assets. This reversal of the usual burden of proof is not justified by the aggregate likelihood of success of chapter 11 debtors. As noted above, only about 15 percent of chapter 11 cases result in confirmed plans. Continued public acceptance of chapter 11 requires that the exceptional privileges accorded chapter 11 debtors be confined to those cases in which creditors and the public benefit thereby—cases in which there is a genuine prospect of successful reorganization. The Commission attempts to further that goal by providing the courts with more appropriate criteria for deciding motions to convert or dismiss.

The proposed amendment of §1112 should be made applicable to all chapter 11 cases.

The proposed amendment of §1112 identifies certain objective benchmarks of likely failure of a chapter 11 case as "cause" for conversion or dismissal. These benchmarks can be grouped into three general categories.

  • Diminution of the estate: e.g., significant or continued post-petition losses.
  • Failure of the debtor to play by the rules of chapter 11: e.g., failure to attend the meeting of creditors, failure to file schedules, failure to file monthly operating reports, failure to obey court orders, or unauthorized use of cash collateral that is harmful to a creditor.
  • Inappropriate business practices: e.g., failure to maintain appropriate insurance, gross mismanagement of the estate, or failure to pay post-petition taxes or file post-petition tax returns.

If, but only if, the moving party establishes one or more of these benchmarks of likely failure, the burden shifts to the debtor to show why the case should not be converted or dismissed. To meet this burden, the debtor must show it is more likely than not (not merely possible) that the debtor will confirm a plan within a reasonable time. In addition, if the benchmark is an act or omission by the debtor, such as failure to attend the meeting of creditors, the debtor must also show some excuse for the act, and that the act or omission will be corrected promptly. This shifting burden of proof is the most significant change from present law. Currently, for instance, the creditor must prove that debtor is not likely to reorganize, even after the creditor has established that the debtor is losing money post-petition.

The Commission's proposed amendment of §1112 creates an appropriate means to identify chapter 11 cases with no genuine prospect for reorganization. First, the proposal is fair to debtors. A debtor is subjected to heightened scrutiny only on the basis of the debtor's own post-petition conduct. Second, the proposal will further uniformity by providing objective standards for conversion or dismissal. Third, the proposal bolsters the legitimacy of chapter 11 by harmonizing chapter 11 and traditional law regarding injunctive relief. The Commission adopts a middle ground under which the debtor must show that reorganization is likely only after a creditor has established that the debtor has incurred further losses or has engaged in inappropriate post-petition conduct. Fourth, the proposal preserves the traditional adversary system in which the judge decides disputes brought before the court by the parties. Fifth, the proposal does not create the additional expense of employing an examiner, a chapter 13-type trustee or some other expert to assess the business viability of the debtor.

There is one respect in which the Commission's proposal could be improved. The proposed amendment of §1112 should be made applicable to all chapter 11 cases. As it is drafted now, the proposal applies only to "small business" chapter 11 cases. Although it is probably appropriate to limit the fast-track provisions to small cases, there is no justification for applying different versions of §1112 to large and small cases. Section 1112 defines substantive rights that should be the same in all chapter 11 cases. The objective criteria for dismissal or conversion identified in the Commission's proposal are suitable for large chapter 11 cases as well as small ones.

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Monday, December 1, 1997