REMEDIES UPON DEFAULT OR DISMISSAL OF CONFIRMED PLAN

(COMMISSION TRACK NUMBER 312)

Present Law

Section 1141 of the Bankruptcy Code provides that upon confirmation of a plan of reorganization, pre-bankruptcy debts are discharged and creditors are entitled to receive only what the plan provides. Some plans specify the consequences which arise upon a plan default either with respect to specific class of creditors, e.g., priority tax claims, or with respect to creditors generally. Other plans do not have specific default provisions, or have default provisions which prove inadequate to address the issues which arise.

In addition, section 1112 of the Bankruptcy Code permits conversion (fn. 108) or dismissal for, inter alia, inability to effectuate a plan, inability to effectuate substantial consummation of a confirmed plan, or a material default under a confirmed plan. Thus, issues arise with respect to the treatment of claims under a confirmed plan where (a) there has been a default, but neither conversion nor dismissal (a "Plan Default"); (b) the case has been dismissed; or (c) the case has been converted.

In each of these circumstances, there are two key questions: first, may a creditor take individual and unilateral action, or must he avail himself of the collective bankruptcy process. For example, upon a Plan Default, may an individual creditor file suit or, in the case of the IRS, pursue administrative collection procedures, or must that creditor first seek conversion or dismissal of the bankruptcy case? Existing law on this subject is unclear in the case of a Plan Default. By contrast, where the case is dismissed, it is clear that the creditor may act unilaterally "as though the bankruptcy had never occurred," (fn. 109) and in the case of a conversion, the creditor is limited to the collective bankruptcy process, except to the extent that the claim is non-dischargeable (fn. 110).

The second question is: may the creditor assert its pre-confirmation claim, or is it limited to the rights afforded under a plan of reorganization. Thus, for example, if a plan of reorganization proposes payment of 25% over time in full satisfaction of unsecured creditor claims and there is a subsequent material default, may unsecured creditors assert claims at the pre-confirmation amount (100%) or only at the post-confirmation amount (25%). Similarly, if a priority tax claim is treated under a plan of reorganization and there is a subsequent conversion, does that claim remain entitled to priority tax treatment? Following a Plan Default, may it be enforced as a tax claim instead of a contract claim? If any administrative or non-tax priority claim is to be paid over time under a plan and there is a material default before payment has been completed, does the claim preserve its administrative or priority character in a subsequent Chapter 7 case?

Existing law on this question is relatively clear in the case of a dismissal: claims are restored to their nature, extent and priority pre-confirmation. There is far less clarity in the case of a Plan Default or conversion, with some courts relying on a strict construction of section 1141 to limit all creditors to contract rights under the plan while other courts rebel against this type of "the last shall be first" approach, in the absence of policy rationale.

Proposals Before the Commission

Commission Track Number 312. A proposal before the Commission would provide that upon dismissal of or default in the plan, the administrative powers and rights of a governmental unit to collect taxes as they existed prior to the filing of the petition are reinstated, including but not limited to, the assessment of taxes, the filing of a notice of lien, and the powers of levy, seizure and sale.

See Unnumbered Government Working Group Proposal; Santa Fe Discussion Issues, p. 11, Item IIB9; IRS Proposal, p. 42; Justice Proposal, p. 83.

Task Force Position

The Task Force opposes this draft proposal as inadequate and recommends an alternative proposal under which the issues of postconfirmation Plan Default, conversion and dismissal would be resolved with respect to all creditor claims in a fashion consistent with the principles of the Bankruptcy Code. The Task Force recommends the following amendments to the Bankruptcy Code:

Insert as new Section 1141(e):

(e) The rights and remedies of creditors and classes of creditors in the event of a default under a confirmed Plan of Reorganization shall be as specified in the Plan of Reorganization. To the extent that those rights and remedies are not so specified, no creditor may take unilateral action to enforce its claim except by filing a motion under section 1112.

Insert as new Section 1112(g) and (h):

(g) In the event that the Court shall convert a case after confirmation of a Plan of Reorganization, all claims subject to treatment under the Plan shall allowed with the same nature, extent, enforceability and priority as those claims enjoyed prior to the commencement of the case or the confirmation of the Plan, as the case may be. Notwithstanding the foregoing, an unpaid claim under section 503(b) which arose prior to confirmation of the Plan shall be subordinate in priority to a claim under section 503(b) which arose subsequent to conversion.

(h) In the event that the Court shall dismiss a case after confirmation of a Plan of Reorganization, all claims shall be restored to the nature, extent and enforceability those claims enjoyed prior to the commencement of the case or the confirmation of the Plan, as the case may be, and holders of claims may enforce their rights, including the rights of holders of tax claims to lien, levy and seize property, without regard to the case.

Insert as final sentence to Section 301:

In the event that a voluntary petition shall be filed prior to the completion of performance under a Plan which has been confirmed under 1129, 1225 or 1325, the provisions of section 1112(g) shall apply to claims treated under the prior Plan, to the extent that such claims have not previously been paid.

Reasons for Position

The Task Force concludes that the draft proposal is inadequate for two reasons. First, with respect to tax claims, the draft proposal is undesirable, inasmuch as it purports to prevent plans of reorganization from prescribing the consequences of a default with respect to tax claims; this limitation is not desirable as a matter of practice or policy. Second, the draft proposal is inadequate because it does not provide guidance on the treatment of the comparable issue in a non-tax context. (The Task Force does not oppose the draft proposal with respect to dismissal of the case, but notes that in that limited circumstance the proposal is merely reflective of existing law.)

Under the draft proposal, any default under a plan would permit the taxing authorities immediately to enforce its non-bankruptcy right. As drafted, a non-monetary default or a default in the treatment of the third party would trigger this enforcement mechanism. As drafted, the provision would not require an opportunity to cure or even notice, such that even if the party suffering the default consented to the default the taxing authority would be free to exercise its remedies.

More fundamentally, well-drafted plans of reorganization include default provisions. Creditors, for example, may negotiate for a mechanism through which the business is sold or liquidated in an orderly fashion upon the occurrence of a default. A debtor may engage in a post-confirmation loan work-out under which certain creditors agree to defer or forgive a portion of the plan payments so that the debtor may continue to fund, e.g., required payments to taxing authorities under the plan. All of this is consistent with the primary policy objective of the Bankruptcy Code -- maximization of value for creditors through a collective proceeding. Where a plan contains default provisions which have been confirmed by the court, there is no policy justification for overriding those provisions to permit the taxing authorities to exercise administrative remedies which, ordinarily, will prevent the realization of maximum value from the reorganized debtor's business, and will sacrifice the collective benefit for the taxing authority's forced sale.

There is no reason to alter the rule based on the prospect that some plans will be confirmed which do not include default provisions. A collective proceeding having been begun, it is not an unreasonable burden to require that creditors either demand reasonable default provisions as part of the plan confirmation process or move the Court to convert or dismiss, whichever shall appear to be in their individual best interests, in the event of a future Plan Default.

The draft proposal is inadequate inasmuch as it does not address the treatment of the claims of creditors other than taxing authorities in the event of a Plan Default. The Task Force proposal treats all creditors in a similar fashion, which is also consistent with bankruptcy principles:

1. Plan provisions which have been negotiated or disclosed as part of the disclosure process and approved by the Court govern; otherwise

2. The collective proceeding must collectively be resolved through a motion to convert or dismiss before creditors can take unilateral action; and

3. Ordinarily, the rights of creditors after conversion and dismissal will be the same as the rights prior to confirmation.

It is submitted that the foregoing provisions are consistent with a few basic principles. First, if creditors negotiate plan default provisions, those negotiated provisions should stand. One of the core policies behind Chapter 11 of the Bankruptcy Code was to foster negotiated resolutions.

Second, creditors engaged in a collective proceeding accept burdens and negotiate rights based on the existence of a collective proceeding. Often, after a plan of reorganization has been confirmed, the collective nature of the proceeding continues to dominate the views of the participants. Where a collective proceeding has been commenced and proceeds on the basis of a prohibition against unilateral action, it is inappropriate to permit unilateral action without some variety of notice to potentially affected other parties. By requiring the issue of a collective proceeding to come to rest in the form of conversion or dismissal, creditors enjoy notice and an opportunity to urge either continuation of the collective proceeding (conversion) or an end to the collective proceeding (dismissal).

Finally, the expectation of creditors in the plan of reorganization process is that they are trading promises for performance, e.g., an unfulfillable promise of immediate payment in full in return for payment of 25% over time, which payment a court has independently concluded to be feasible. Section 1129(a)(11). If, in fact, the plan does not prove to be feasible, creditors do not expect that they have traded a 100% claim for a 25% claim solely in order to enjoy an initial unsuccessful "roll of the dice."

It should be noted that applying this rule will result in two chronologically disparate "priority periods": to the extent that a plan permits the payment of priority taxes over time, and to the extent non-tax priority creditors consent to payments over time, they will preserve their priority in a subsequent Chapter 7 case, even though they would not otherwise enjoy that priority due to the date that the claims were originally incurred. This is appropriate, since absent such a priority reasonable administrative and priority creditors would not accept the payment deferrals and would instead insist upon their statutory right to immediate payment in full.

The only proposed exception to the "preservation of priority" approach is with respect to unpaid Chapter 11 administrative claims to be paid under the defaulted plan. While a type of administrative claim status is preserved, it is proposed that "old" Chapter 11 administrative claims be junior to "new" Chapter 11 administrative claims and Chapter 7 administrative claims. This approach is consistent with the general policy of affording first priority to the undertaker so as to assure that subsequent administration and burial will be possible, see, section 726(b).

*************************FOOTNOTES********************************

fn. 108: References to "conversion" mean converting a chapter 11 (reorganization) case to a chapter 7 (liquidation) case. In chapter 7 the debtor's assets are sold and distributed to creditors and equity owners according to statutory order of priority. There is no plan submitted for a vote.

fn. 109: See Bankruptcy Code Section 349.

fn. 110: See Bankruptcy Code Section 348.

Questions, comments or suggestions? kbercik@taxcounsellor.com

Last updated June 1, 1997