Hot Off the Press – Preference and KERP Developments under BAPCPA?
by: David Conaway
Shumaker, Loop and Kendrick, LLP; Charlotte, N.C.
There appears to be a showdown brewing in the U.S. Bankruptcy Court for the Southern District of New York, and the 2005 amendments to the Bankruptcy Code will be front and center.
As was widely reported in 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), among other things, severely limited a chapter 11 debtor’s ability to pay retention and severance payments to management. Prior to the effective date of BAPCPA (cases filed on or after Oct. 17, 2005), payments to management pursuant to a key employee retention plan (KERP) were common in virtually all large chapter 11 cases.
BAPCPA, however, prohibits a debtor from making KERP payments unless the debtor can meet the following requirements:
- The proposed payment is essential due to a bona fide job offer from another business at equal or greater compensation;
- The person’s services are essential to the survival of the business; and
- The payments are limited to 10 times similar payments paid to non-management employees.
On June 29, 2006, in the Dana Corp. chapter 11 proceeding pending in the Southern District of New York, the debtors filed a motion seeking approval to pay the core executive team as much as approximately $15 million. A hearing, on Dana’s motion has been set for Sept. 5, 2006. To date, Dana’s unsecured creditors committee, the ad hoc noteholders’ committee and Dana’s unions (the UAW and USW) have all filed objections to Dana’s motion. All three of these creditor constituencies cite BAPCPA’s prohibitions on such payments as the basis for objection. Interestingly, in its motion, Dana did not address how the proposed payments satisfy the new BAPCPA KERP restrictions. Rather, Dana is relying on the bankruptcy court’s broad powers to authorize nonordinary-course-of-business transactions or contracts, and requested that the court defer to Dana’s business judgment.
Unless the parties agree on some lesser amount and settle this dispute, it appears as if there will soon be a ruling on the KERP restrictions of BAPCPA in a major U.S. chapter 11 case. If the parties agree on some lesser amount, perhaps the Dana case suggests a strategy around the BAPCPA prohibitions – make a request for payments, settle for a lesser amount, but still receive what arguably would have been prohibited under BAPCPA. It is conceivable that the Dana court will use its broad powers to essentially override the BAPCPA KERP restrictions. However, courts generally uphold specific statutory prohibitions in the exercise of general powers.
New Preference Decision under BAPCPA
In what must be one of the very first reported “preference” decisions under BAPCPA, the U.S. Bankruptcy Court for the Eastern District of North Carolina recently interpreted the BAPCPA change to the “ordinary course of business” defense. In connection with the National Gas Distributors LLC (NGD) bankruptcy case, the trustee for NGD sued Branch Banking & Trust Company (BB&T) to recover in excess of $3.2 million of allegedly preferential payments. The essence of BB&T’s defense was that the payments were in the ordinary course of business.
BB&T had provided unsecured lines of credit to NGD totaling $3.5 million. The maturity dates for both credit lines had been extended several times until the final extension of Dec. 23, 2005. In addition, the husband and wife principals of NGD had guaranteed payment of the obligations to BB&T. Moreover, the wife’s personal assets were pledged as collateral to secure the guaranties. On Dec. 15, 2005, eight days prior to maturity, NGD paid approximately $3.2 million to BB&T in full satisfaction of the balances owed under the lines of credit. A few days later, NGD paid BB&T another $850,000 to collateralize the letters of credit. In connection with these payments, BB&T released the wife’s assets as collateral for the lines of credit. On Jan. 20, 2006, NGD filed for chapter 11 protection.
The trustee sued BB&T to recover the payments as transfers within 90 days prior to the chapter 11 filing, in this case about 35 days prior to bankruptcy. BB&T defended itself by asserting that the payments were made in the ordinary course of business.
Under pre-BAPCPA law, to prove the ordinary-course-of-business defense, a preference defendant was required to demonstrate that the payments were made in the “ordinary course of business” and were made within “ordinary business terms” (meaning within industry standards). The key BAPCPA change was changing “and” to “or” such that a defendant need only prove the payments met one, not both, of the prongs of the test. The bankruptcy court in the NGD case confirmed that a preference defendant need only prove one of these prongs of the ordinary course of business defense to prevail in a preference action.
BB&T chose to prove that the payments were within “ordinary business terms” or within industry standards. In support of this position, BB&T proffered an affidavit stating that in BB&T’s experience and the banking industry generally, it was common for borrowers to pay notes upon maturity or within several weeks before maturity. The bankruptcy court reasoned that it was not appropriate to look solely at the creditor’s industry; rather, courts must examine industry standards of both the debtor and the creditor, as well as general business standards that are common to all businesses.
The bankruptcy court found that it was not standard for NGD to pay off all of its corporate loans without first securing replacement lending, especially where the payments clearly benefited the insiders. The court concluded that the $3.2 million of payments were not standard for any business and not consistent with sound business practices in general.
On its face, this case appears to be a “classic” preference case where the debtor, on the eve of bankruptcy, preferred a creditor to whom the insiders had provided personal guaranties. Nevertheless, the court’s thorough discussion of the ordinary-course-of-business defense post-BAPCPA should provide useful guidance for creditors in future cases.
Editor’s Note: The opinion cites both an ABI Law Review article and the ABI Task Force on Preferences’ (TFP) report, which influenced the development of the statute being interpreted here. The TFP was chaired by UTC Committee Chair Joe Bodoff. At the time of publication the bankruptcy court in the Dana case denied the KERP relief sought by the Debtor, just as anticipated by the author.