The Examiners: Fix Bankruptcy Code’s ‘Errors and Glitches’

If you could make one change to the bankruptcy code, what would it be?

As many commentators have noted, bankruptcy has become very litigious. Much of this is likely unavoidable, as aggressive and aggressively represented parties jockey for leverage and recoveries. That said, some litigation arises from what are almost universally agreed to be typos or drafting glitches. So, in the spirit of public service, I am resisting the impulse to pick one of the several major policy issues that I believe should be differently addressed in the code. Rather, my “one change” is to fix some troublesome errors and glitches in the code, which would save parties needless expenses.

• The section of the bankruptcy code dealing with contracts and leases—specifically, section 365(c)(1)—gives effect to non-bankruptcy law that restricts the assignment of certain contracts, such as intellectual property licenses, to third parties. However, the inartful statutory language has led many courts to conclude that a debtor can’t even assume (keep for itself with no changes) such contracts because they hypothetically could not be assigned to a third party. This is nonsensical and needs to be fixed by changing “the trustee may not assume or assign” to read “the trustee may not assume and assign.”
• Read literally, as certain courts have, the safe-harbor provisions of section 546(e) protect most securities and derivative transactions from avoidance actions brought by the debtor or trustee—but not if brought by creditors. Congress clearly did not intend this interpretation, which is in irreconcilable tension with the policy underlying this part of the code and the clear intent to offer safe harbors to certain types of transactions. The section of the code should be clarified to bar avoidance actions brought by any party.
• The definition of “debtor” in section 109(a), which the Second Circuit recently ruled applies in Chapter 15 cases, directly conflicts with section 1502(1), which defines “debtor” within Chapter 15 itself, meaning that an entity can be eligible to file for Chapter 15 under section 1502(1) but ineligible under section 109(a). Quite simply, another glitch—and section 109(a) should not apply to Chapter 15 cases.
• The reference to section 927 in section 922(d) is incorrect. The reference should be to section 928 instead, which governs the postpetition treatment of pledged special revenues.
• The Supreme Court in 2012 ruled that a debtor may not “cram down” a nonconsensual Chapter 11 plan in which the debtor’s assets are to be sold free and clear of a secured creditor’s lien unless the secured creditor is entitled to “credit bid” for the assets (i.e., use its debt as currency to bid for the debtor’s assets). Invoking the “specific trumps the general” statutory maxim, the Supreme Court held that subsections (i) and (ii) of section 1129(b)(2)(A) apply in plans under which, respectively, (i) the creditor’s lien remains on the property and (ii) the property is sold free and clear of liens, concluding that if prong (i) or (ii) applies then prong (iii), which allows the plan to provide the secured creditor with the “indubitable equivalent” of its claim, necessarily does not. Previously, debtors had used prong (iii) successfully to prohibit secured creditors from credit bidding and cram down asset sale plans over their objections even though prong (ii) expressly permits credit bidding in asset sale plans. Section 1129(b)(2)(A) should be fixed to make this clear.
• Section 507(a)(8) specifies the priority of certain unsecured tax claims but is silent with respect to secured tax claims. Section 1123(a)(1) provides that a plan shall designate classes of claims “other than claims of a kind specified in section 507(a)(2), 507(a)(3), or 507(a)(8).” Thus, the statute appears to provide that unsecured tax claims may not be classified under a plan but that secured tax claims must be, despite that Congress added section 1129(a)(9)(D) in 2005 to provide equal treatment for these two types of claims. This glitch creates unintended (and counterintuitive) consequences. For example, courts have found that a class of secured tax claims can constitute an accepting impaired class for purposes of cramming down a plan over dissenting classes under section 1129(a)(10), even though a class of unsecured tax claims could not. This should be fixed by amending section 507(a)(8) to refer to both secured and unsecured tax claims.

Marshall Huebner is a partner with Davis Polk & Wardwell LLP in New York and is co-head of the firm’s insolvency and restructuring group.