The Bankruptcy Abuse

Sales of debtors’ assets in bankruptcy proceedings are quite common, either as part of a plan of reorganization or liquidation or pursuant to Bankruptcy Code Section 363. The Bankruptcy Code and the Federal Rules of Bankruptcy Procedure provide that a sale of a debtor’s assets occurs after notice to all creditors and an opportunity for a hearing. In the case of a not for profit entity (an “NFP”), the ability of a debtor to sell its assets in a bankruptcy often overlaps with various state laws and regulations governing NFP asset sales.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the “Bankruptcy Act”) signed into law by President Bush on April 20, 2005, will have an immediate impact on sales of NFP debtor assets. While most of the recent amendments to the Bankruptcy Code will not become effective until October 17, 2005, the amendments discussed herein became effective on April 20, 2005 — for both new and pending bankruptcy cases.

As a result, the changes the Bankruptcy Act made to Bankruptcy Code Sections 363, 541, and 1129 are presently in effect and parties involved in bankruptcy cases of NFP’s should be aware of their existence and plan accordingly. Prior to the amendments, the relationship between the bankruptcy law governing asset sales and other applicable nonbankruptcy law governing the sale of assets by NFPs was less than clear.

For example, state laws and regulations often established procedures, usually enforced by a state’s attorney general, which governed the sale of NFPs’ assets. Advance notice of a proposed sale might be required, including details such as the seller’s name, price for the assets, and the specific terms of the sale agreement. In addition, state law might require public hearings or other mechanisms to support a finding that the sale of an NFPs’ assets is in the public interest.

Often there are state law restrictions on the sale of NFP assets to a for-profit enterprise. Conversely, sale proceedings under the Bankruptcy Code are geared to provide the highest and best offer for a debtors’ assets so as to maximize the return to creditors. As a result, it was unclear whether NFP debtors were required to obtain only the approval of the bankruptcy court and/or also needed to comply with otherwise applicable law.

Some courts permitted NFP debtors to transfer assets through a Section 363 sale without complying with state laws and regulations, even over the objection of a state’s attorney general. Other courts, however, required compliance with both the Bankruptcy Code and applicable nonbankruptcy law. Pursuant to the Bankruptcy Act, the sale of a NFP debtor’s assets pursuant to Section 363 must now be “in accordance with nonbankruptcy law that governs the transfer of property by a corporation or trust that is not a moneyed, business, or commercial corporation or trust.

” 11 U. S. C. § 363(d)(1). Similarly, if the NFP debtor’s assets are to be sold pursuant to a plan of liquidation or reorganization, new Section 1129(a)(16) provides that a plan of a NFP debtor may only be confirmed if all transfers of property are “made in accordance with any applicable provisions of nonbankruptcy law that govern the transfer of property by a corporation or trust that is not a moneyed, business, or commercial corporation or trust. ” 11 U. S. C. § 1129(a)(16). 2

Bankruptcy Code Section 541 was amended to add a new subsection (f) which provides that if the NFP is a tax exempt entity under Internal Revenue Code Section 501(c)(3) its assets may nevertheless be sold to an entity that is not an Internal Revenue Code Section 501(c)(3) entity, “but only under the same conditions as would apply if the debtor had not filed a . . . [bankruptcy]. ” 11 U. S. C. § 541(f). Finally, the Bankruptcy Act at Section 1221 makes clear that the state attorney general for the state which the debtor is either incorporated, was

formed, or does business, has standing to appear and be heard in any proceeding relating to the sale of an NFP’s assets (although this provision was not codified into the Bankruptcy Code itself). While it is too early to determined the impact of these amendments, it appears from the limited legislative history that the congressional intent of the amendments was to give greater influence to state regulators and attorneys general and “restrict the authority of a trustee to use, sell, or lease property by [sic] a nonprofit corporation or trust.

” H. R. Rep. No. 109-31, pt. 1, at 145 (2005). How these new amendments are to be applied in practice remains to be seen. For example, which process should be followed first is not clear. Because a bankruptcy court cannot approve a sale unless it is authorized under applicable nonbankruptcy law, one might conclude that the nonbankruptcy procedures should be followed first.

However, because an NFP debtor may not know the exact terms of a sale or even the name of the buyer, until the bankruptcy sale process is near completion, the alternative argument that the bankruptcy procedures should proceed first is an equally logical conclusion. This much is clear — the applicability of additional bodies of law will increase the transaction cost for any NFP seeking to sell its assets in bankruptcy. At the same time, these additional restrictions will reduce the potential universe of buyers of a NFP debtor’s assets.

NFP debtors seeking to sell their assets in a bankruptcy case must now consider issues other than maximizing the return to their creditors. If you would like further information regarding the Bankruptcy Act, please contact William Kannel ([email protected] com), Adrienne Walker ([email protected] com), the Mintz Levin attorney who ordinarily handles your legal affairs, or visit www. mintz. com. 1 William W. Kannel is a Member and Adrienne K. Walker is an Associate in the Bankruptcy, Restructuring and Commercial Law Section in Mintz Levin’s Boston office. 2 Interestingly, the provisions that govern the content of a plan at Section 1123(a) were not similarly amended. Section 1123(a)(5)(B) provides that “notwithstanding any otherwise applicable nonbankruptcy law, a plan shall . . . provide adequate means for the plan’s implementation, such as [the] sale of all or any part of the property of the estate . . .. ” Copyright © 2005 Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P. C.

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