Creditors Will Crack The Whip

Tough new rules will make corporate bankruptcies quicker and more brutal

UAL Corp.'s United Airlines Inc. (UALAQ ) dodged a bullet on June 17 when a bankruptcy court gave the carrier until Sept. 1 to file a plan to reorganize its operations and finances. It was the ninth extension in a case that has dragged on for 2 1/2 years. But United has plenty of company on the bankruptcy treadmill. Floor-products maker Armstrong World Industries Inc. (ACKHQ ) has been operating under Chapter 11 protection since 2000. Adelphia Communications Corp. (ADELQ ) spent nearly three years in bankruptcy before agreeing in April to sell its cable-TV assets to Time Warner Inc. (TWX ) and Comcast Corp. (CMCSA ).

Now under the new bankruptcy law that President George W. Bush signed on Apr. 20, future corporate debtors will find their stay in court far shorter -- and much less comfortable. The law sharply limits a company's ability to run out the Chapter 11 clock. It puts stiff new curbs on what bankrupt companies can pay to keep key executives, which could speed their exodus and make restructuring even tougher. The changes, most of which take effect for cases filed after Oct. 17, will require many companies operating under Chapter 11 protection to make decisions faster and pay back more of their debts. The new law strongly tilts the balance toward creditors and will force more companies to liquidate rather than work out their financial problems.

"Cases will be quicker and more brutal," predicts Thomas M. Mayer, a bankruptcy specialist and partner in the New York office of Kramer Levin Naftalis & Frankel LLP. Mayer and other lawyers expect a late-summer rush by troubled companies filing before the new rules kick in. The law gives all creditors more leverage, but suppliers, landlords, and investment banks will fare especially well.

Some experts think the revisions to the bankruptcy code are long overdue. The proliferation and long duration of business cases drove up fees for lawyers and managers' pay, while creditors were forced to cool their heels. "The discretion and latitude that courts give debtors has permitted a feeding frenzy" for execs, attorneys, and workout firms, fumes Lewis S. Rosenbloom, a partner at law firm McDermott Will & Emery LLP in Chicago.

Congress sought to crack down on business deadbeats mainly by limiting the leeway bankruptcy judges have to determine the duration of cases and allow exceptions. For example, a company that files for Chapter 11 will have 18 months, tops, to submit a restructuring plan. After that, creditors or other interested parties may offer their own plans.


Lawmakers also tied the courts' hands on lavish retention pay for managers. Since the 1990s, so-called key employee retention plans -- offering "pay to stay" bonuses to managers -- have become a staple of business bankruptcies.

Critics carp that the practice is misguided, rewarding the team that steered the company into trouble. A 1989 study by Harvard Business School professor Stuart C. Gilson showing that chief executives who depart big bankrupt companies rarely land top jobs elsewhere supports the view that such managers don't deserve rewards. "A senior manager who leaves a sinking ship is not likely to get another ship," says Lynn M. LoPucki, a law professor at the University of California at Los Angeles School of Law and author of Courting Failure: How Competition for Big Cases Is Corrupting the Bankruptcy Courts.

As executive pay soared, so did retention bonuses, spurring charges of abuse. In 2002, a judge presiding over the bankruptcy of the former WorldCom Inc. approved a $25 million payout to 329 employees. Sometimes, managers take the money and run. That's what happened to the $28.5 million in retention "loans" that Kmart Corp. granted 22 executives in December, 2001. The financially troubled retailer said it would forgive the loans if the managers stuck around through a reorganization. In January, 2002, Kmart filed for Chapter 11 -- and by the end of March, 16 of the 22 execs had left. Some executives repaid, and Kmart and its creditors sued others who did not return the money.

Courts are already cracking down on pay-to-stay bonuses. On June 15, the judge in Alexandria, Va., overseeing US Airways Group Inc.'s bankruptcy excluded 23 senior officers from a plan, worth up to $55 million, that aimed to keep more than 1,800 managers at the carrier during its merger talks with America West Holdings Corp. (AWA ). The proposal had triggered a storm of protest from US Air's unions, which already have accepted nearly $1 billion in pay and benefits cuts. "There is something inherently unseemly in the effort to insulate the executives from the financial risks all other stakeholders face in the bankruptcy process," Judge Stephen S. Mitchell wrote in his opinion.

The new law caps any executive's retention pay at 10 times the average amount offered a rank-and-file worker. And it lets a manager get retention pay only upon proof of a job offer that pays as much or more than current compensation. That will squelch most such bonuses and prompt managers to leave, hollowing out the management structure needed to carry out a reorganization. "You'll get outside managers coming in that may not be as well versed in the industry," says William K. Lenhart, national director of financial recovery services at BDO Seidman LLP.

Courts face curbs, too, on their ability to give bankrupt companies that hold leases ample time to decide which leases to keep and which to break. The change will be painful for retailers and grocery and restaurant chains. Under current law, debtors have 60 days from filing for Chapter 11 to assume or reject a lease -- but courts have granted repeated extensions. Shopping center owners, for whom failed chains are a drag on malls and sometimes an impediment to financing, lobbied successfully for a 210-day cap on the time companies have to assume or reject leases. "If you can't decide within seven months what's happening with your stores, you should be forced to give the space back," says Gary D. Rappaport, a shopping center developer in metropolitan Washington.


But forcing faster decisions on leases will make it harder for a retailer that is reorganizing to analyze whether its new merchandising plan is working, Lenhart argues. Most retailers monitor store sales trends for at least a year, including the critical Christmas shopping season.

The new bankruptcy law allows more leniency in some areas -- but not for the debtor. Vendors who don't get paid for goods shipped to a debtor within 20 days of a filing can get a priority claim that requires them to be paid in full before a court okays a reorganization plan. And suppliers can reclaim unpaid goods shipped within 45 days of a filing. Current code keeps creditors waiting to be paid until after the reorganization -- and they'll get paid only if the goods were shipped with 10 days of the bankruptcy filing.

The new law gives Wall Street firms a waiver of a rule that guards against conflicts of interest on the part of advisers. No longer will investment banks that underwrote securities for companies that ended up in bankruptcy be barred from offering advice to the same companies.

Bankruptcy lawyers are bracing for a rush to file before the current rules expire. That hasn't happened yet. Business filings actually fell 13.1% in the year ended Mar. 31, to 31,952 cases. But as word gets out about the new law's tough requirements, a stampede to the bankruptcy courts seems inevitable.

By Amy Borrus in Washington

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