Impacts of Stimulus Legislation on the Bankruptcy Code: Debtor Eligibility and Preference Exceptions

As the pandemic enters its tenth month, the CAA provides some attention to the needs of already-faltering businesses by creating additional rights for debtors in bankruptcy, as well as a preference safe harbor for certain creditors providing goods and services to faltering businesses, through a series of pointed revisions to the Bankruptcy Code, 11 USC §§ 101 et seq. (the “Code”). As with the CARES Act, however, the CAA generates substantial uncertainty about the extent that this relief will be available to debtors in bankruptcy and when.

I. Some Debtors Intended to be Eligible for PPP Loans, Maybe.

The CAA appropriates $284.45 billion to reopen the PPP program that closed to new borrowers on August 8, 2020 and for a second round of PPP loans for existing borrowers that exhausted their initial PPP loans. The Small Business Administration (“SBA”), the agency charged with implementing the PPP, previously promulgated regulations disqualifying all bankruptcy debtors from the program. Its most recent draft regulations, released after the enactment of the CAA, reiterate that bankruptcy debtors remain ineligible to participate in the program. The SBA’s initial regulations were challenged in bankruptcy and appellate courts across the country with mixed results that created widespread uncertainty about the qualification of debtors for PPP loans. The CAA resolved that uncertainty by substituting for it a new form of uncertainty. The CAA amends Section 364 and other sections of the Code to allow debtors-in-possession (and trustees) in bankruptcy proceedings under chapters 12, 13, and subchapter V of chapter 11 to obtain PPP funds if they are otherwise eligible—but the amendments will go into effect only once the SBA determines that debtors-in-possession or trustees would be eligible for PPP loans. Under the SBA’s most recent guidelines debtors continue to be ineligible for PPP loans.  A change in this policy would only happen if the SBA revises its guidelines to implement the CAA’s proposal, but the SBA appears able to delay that implementation indefinitely.

If the CAA’s amendments to the Code do take effect, the debtor must apply to the bankruptcy court for approval of the PPP loan, and the bankruptcy court must hold a hearing on such approval within seven days of the debtor’s application—an expedited timeline that emphasizes Congress’s intent to provide speedy relief to struggling debtors. Once approved, PPP loans would be treated as super-priority administrative expenses under Sections 364(c)(1) and 503(b) of the Code, unless and until they are forgiven. The contingent amendments to Section 364 also provide that a debtor may obtain a PPP loan notwithstanding existing cash collateral or debtor-in-possession lending arrangements that would otherwise prohibit subsequent borrowing. Furthermore, the Code’s relevant plan confirmation provisions would also be amended to permit confirmation of a plan that pays a PPP loan according to its terms notwithstanding the super-priority status of PPP loans in bankruptcy. It will be interesting to see if the SBA directly responds to the CAA and if courts will be asked to intervene and interpret the CAA to require that the SBA promptly initiate relief for these struggling debtors.

II. Certain Creditors Receive New Safe Harbor From Preference Actions

Creditors of troubled companies generally know to be wary of “catch-up” payments and other transfers made outside of the ordinary course of business, as Section 547 of the Code allows such payments to be clawed back as “preferences” if made within 90 days before a debtor’s bankruptcy filing. Yet, the pandemic has in many ways turned the notion of “ordinary course of business” on its head, making catch-up payments the rule rather than the exception in debtor-creditor relationships. The CAA attempts to alleviate preference risks from the widespread business disruption by creating a temporary safe harbor for “covered payment[s] of rental arrearages [and] … supplier arrearages.” These terms refer to certain arrearage payments, either to a lessor of non-residential real property or a supplier of goods or services, made by the debtor pursuant to an “agreement or arrangement” entered into on or after March 13, 2020 to defer or postpone the payment of amounts due.

The CAA states that a “covered payment” of supplier arrearages may not: (a) “exceed the amount due under the executory contract [for goods or services] before March 13, 2020” or (b) “include fees, penalties, or interest [to be paid under the executory contract] in an amount greater than the amount of fees, penalties, or interest—(I) scheduled to be paid under the executory contract … or (II) that the debtor would owe if the debtor had made every payment due under the executory contract … on time and in full before March 13, 2020.” There are three key takeaways from this muddled statutory language:

1. The supplier contract underlying the payment deferral agreement must be an “executory contract,” which means there must be material, unperformed obligations of both the debtor and the supplier to qualify.

1. To fit within the preference safe harbor, the payment must not exceed the amount that was due before March 13, 2020.

1. Further, that protected amount cannot include late fees, penalties, or default interest for failing to make payments that came due before March 13, 2020.

The treatment of payments to commercial lessors is addressed in a separate paragraph using somewhat different language. Whereas covered payments to suppliers are tied explicitly to the amount due before March 13, 2020, covered payments to commercial lessors may “not exceed the amount of rental and other periodic charges agreed to under the lease of non-residential real property … before March 13, 2020.” The intent of the statute appears to limit the lessor’s safe harbor to amounts collected during a preference period only to the extent those payments are not in excess of the amounts provided for under the lease (such that the lessor could not protect any payment that has been enhanced under the terms of the forbearance agreement); however, there remains a question as to whether the specific language of the statute accomplishes this intent.

For all covered payments, it is clear that the creditor must enter the qualifying forbearance agreement or arrangement prior to making the arrearage payments (and, of course, prior to the debtor’s bankruptcy filing). What is not clear is how the courts will construe the many other chronologically complex or ambiguous terms contained in the legislation. Nevertheless, commercial landlords and suppliers are provided with some incentive to cooperate with struggling customers and tenants, such that they should strongly consider the benefits they might derive from entering forbearance agreements with them now. As with the PPP-related amendments to the Code, these changes to Section 547 will be phased out on the date that is two years after their enactment.

III. Congress Increases Commercial Lease Flexibility for Subchapter V Debtors

The CAA also modifies Section 365 of the Code to provide debtors-in-possession under subchapter V (or subchapter V trustees) the ability to extend the time to perform under any unexpired lease of non-residential real property if the failure to perform is due to COVID-related hardships. Such extension may be granted through the earlier of (i) sixty (60) days from the filing of the bankruptcy case, and (ii) the date that the lease is assumed or rejected by the debtor. The 60-day extension may be further extended an additional 60 days if the bankruptcy court determines that the debtor is continuing to suffer material hardships related to COVID-19. Section 365(d)(4) of the Code is also amended to extend the time for all debtors (not just subchapter V) to assume or reject a non-residential lease to 210 days from the order for relief (rather than the usual 120 days).

The deferred rental payments receive treatment as administrative expenses under Section 507(a)(2) of the Code, which at least affords lessors payment priority, but the benefit unmistakably inures to debtors. The express singling out of “subchapter V” debtors for this treatment suggests that Congress wanted to confine the benefit to small businesses. This distinction will itself take on new meaning on March 27, 2021, when the debt eligibility threshold for new subchapter V cases is scheduled to revert from $7,500,000 to $2,725,625. Although the revisions to Section 365 will also remain effective through December 2022, absent congressional action the population of debtors entitled to enjoy those revisions will soon become substantially smaller.

IV. Other Bankruptcy Code Changes

The CAA contained several other Code changes, each of which automatically expires one year after enactment:

• Section 525 of the Code is modified to clarify that a person may not be denied relief under sections 4022-24 of the CARES Act (pertaining to mortgage payment forbearances and the moratorium on evictions and foreclosures) because of a bankruptcy filing.

• Section 541(b) of the Code is modified so that any rebates representing the direct stimulus checks to families and individuals are not treated as property of the debtor’s estate.

• Section 1328 of the Code is modified to allow chapter 13 debtors to receive a discharge of their debts even if they have defaulted on up to three monthly residential mortgage payments after March 13, 2020 on account of COVID-related hardships, or if they have a forbearance agreement or loan modification in place with their residential mortgage holder and their chapter 13 plan provided for the curing of any mortgage default and maintenance of payments.

• Section 501 of the Code is amended to provide that any mortgage servicer who did not receive forbearance payments previously due in connection with sections 4022-23 of the CARES Act within the applicable forbearance period may now file a supplemental proof of claim in the debtor’s bankruptcy case up to 120 days after the expiration of the applicable forbearance period.

• Section 366 of the Code is amended to provide that no utility provider can cancel, alter or refuse service to any individual debtor who does not provide adequate assurance of payment, so long as the debtor makes a payment to the utility provider during the first 20 days of the bankruptcy and then continues to make post-petition utility payments when due.

• Section 507(d) of the Code is amended to provide that any entity that is subrogated to the right of any holder of a claim for customs duties arising out of importation of certain goods is also subrogated to such claim holder’s payment priority status under the Code.