Maintaining Cash Reserves While Dealing with Revised §366 of the Bankruptcy Code
By Joseph A. Malfitano, Young Conaway Stargatt & Taylor LLP
The ability of chapter 11 debtors to maintain cash reserves is about to get harder. Hurricanes Katrina and Rita have put a dent in the entire nation's economy and likely will have a significant impact on corporate profits for at least the rest of this year. The storms devastated one of the most critical regions in the country for energy production and already have claimed responsibility for record-high prices for gasoline, heating oil, jet fuel and other products. Economists are predicting that energy prices this winter could double or triple. Some corporations have already been put on notice by their energy suppliers that pricing could increase by 100 to 250 percent depending on the timing for restoration of the Gulf refineries.
As widely reported, Congress recently enacted the most comprehensive set of amendments to the Bankruptcy Code since 1978. Although most press accounts of BAPCPA have focused on the provisions affecting consumer bankruptcies, BAPCPA also contains several important provisions affecting business bankruptcies. Many practitioners and academics have specifically focused on the amendment to §365 of the Bankruptcy Code dealing with the debtor's assumption or rejection of real property leases. Indeed, many practitioners predicted that a wave of business bankruptcy filings, especially struggling large retailers would occur before Oct. 17, the effective date of BAPCPA, due to the new time constraints imposed on debtors to assume or reject real property leases under amended §365.
However, in light of the economic devastation caused by Katrina and Rita thus far and their likely impact over the next several months on operating costs for almost every business and industry, the amendments to §366 of the Code may prove to have one of the most significant impact on free cash flow for chapter 11 debtors. (See last week's ABI Quick Poll results on the homepage for the opinion of a sample of ABI members).
BAPCPA amends §366 of the Bankruptcy Code to provide utilities with substantial additional protections. Under current law, debtors often are able to avoid posting additional security in the form of a deposit or letter of credit to procure continued utility service by convincing the bankruptcy court they had an excellent pre-petition payment history and sufficient liquidity to meet utility obligations post-petition.
In addition, debtors argue that in a worst-case scenario, utility service providers will be administrative claimants and thus will be paid in full.
Congress has stripped the debtor of these arguments. Specifically, BAPCPA adds a new subsection (c) to §366, which provides that "assurance of payment" means only a cash deposit, a letter of credit, a certificate of deposit, a surety bond, a prepayment or another form of security that is mutually agreed upon between the utility and the debtor. Importantly, the revised §366 expressly provides that "an administrative expense priority shall not constitute an assurance of payment." If the debtor doesn't provide assurance of payment that the utility believes is satisfactory, the utility may alter, refuse or discontinue service after 30 days of the petition date.
Revised §366 further provides that in determining whether the debtor's assurance of payment is adequate, the court may not consider the absence of security before the petition date, the debtor's excellent pre-petition payment history or the availability of administrative expense priority. Finally, revised §366 provides that "notwithstanding any other provision of law," including the automatic stay, a utility may recover or set off against a security deposit provided to it pre-petition. There is no doubt that the amendment to §366 empowers utilities and imposes a greater financial burden on debtors. The economic impact of the amendment to §366 of the Code could be significant if higher energy costs engendered by Katrina and Rita should prove sustained.
At a minimum, under BAPCPA, a debtor with a large number of facilities, plant locations or heavy energy needs will need to do some considerable planning and budgeting to meet the revised "assurance of payment" requirement of §366 and to avoid the depletion of its cash reserves. Indeed, the survival of a Chapter 11 debtor who consumes a significant amount of energy in its business may be, in some respects, dependent upon early planning and budgeting by a debtor.
To minimize the negative impact on free cash flow, withholding payments to utilities prior to the filing in order to conserve cash, imposition of lender carve-outs for utilities, and complex weekly prepayment and true-up procedures likely will become the norm in large Chapter 11 cases. If energy costs remain a moving target, the question of what is adequate "assurance of payment" also will likely be a more costly topic of litigation in bankruptcy courts across the country.
In addition, given the shift of power to utilities under BAPCPA, the unsettled nature of the definition of "utility" under §366 of the Code, particularly in the telecom industry, will likely continue to be a hot topic.
The fallout from the destruction caused by Katrina and Rita is sending shockwaves through this nation's economy. Along with motorists who are feeling the squeeze at the pump, Katrina and Rita will affect manufacturers and other industries dependent on energy and the transportation of raw materials and finished goods, insurers, casinos, tourism, shippers who were precluded from moving cargo out of the Gulf of Mexico ports, thousands of local businesses in the Gulf and potentially consumers around the globe. With the upcoming shift in power to utilities under revised §366 of the Code, financial advisors will have to be creative and engage in early planning in order to fight off the depletion of their clients’ cash reserves.
Joseph A. Malfitano is an attorney in the bankruptcy and corporate restructuring section at Young Conaway Stargatt & Taylor LLP. The firm's bankruptcy and corporate restructuring section is the largest in Delaware and one of the largest in the Mid-Atlantic region, with more than 30 attorneys and 12 paralegals. The firm typically represents debtors, creditors' committees, purchasers, plan sponsors, future asbestos claimant representatives and shareholder groups. Malfitano can be reached at 302-571-6630 or via e-mail at jmalfitano@ycst.com.