6 the protection of the court. At the same time, such laws should not countenance the erosion of the rights of secured creditors to the extent of limiting the availability of commercial credit at a reasonable cost to new or marginal business enterprises. We feel that this Committee should evaluate the proposed legislation from the perspective of reaching an equitable balance between the rights of creditors and the opportunity afforded to debtors to reorganize under the protection of the bankruptcy court. With this in mind we would like to focus our comments first upon the overall structure of the proposed legislation, particularly the role of the administrator in corporate reorganizations and the abandonment of the relative flexibility of the present Chapter XI to be replaced by the proposed Chapter VII and, secondly, upon certain specific provisions of the Commission Bill: namely, Section 7-203-Use of Property Subject to a Lien; Section 7-204 and 5-201-Setoff and Use of Property Subject to Right of Setoff; Section 7-106-Extensions of Credit; Section 7-101Creditors' and Equity Security Holders' Committees, and Section 4-607-Voidable Preferences. 1. The Role of the Administrator in Chapter VII. Unlike Chapter X, Chapter XI of the Bankruptcy Act has proven to be a relatively successful and flexible vehicle for the reorganization of the vast majority of problem loans where an out-ofcourt workout is not appropriate or possible. The proposed legislation would effect a consolidation of Chapter X and Chapter XI of the Bankruptcy Act and would introduce to the existing reorganization mechanism the unproven, albeit untried, role of the Administrator. We do not oppose the role of the Administrator because it is new. We oppose it because there is no demonstrable need for such a role in business reorganizations generally. Whereas the Commission's Report provides a rationale for the role of the Administrator in consumer bankruptcies, one can seriously question the utility of a bureaucratic overlord in the area of corporate reorganization where the enlightened self-interest of generally sophisticated creditors has proven to be an effective mechanism for compromise and remedial action. 2. Creditors' Committees. The problem posed by the proposed legislation is graphically presented by Section 7-101 of the Commission Bill which would delegate to the Administrator the duty of appointing the Official Creditors' Committee. Since the success of an arrangement under Chapter XI depends upon the ability of a debtor to reach an accommodation with those creditors with the most significant economic stake in the proceeding, the Official Committee, as elected under existing law, would appear to be a preferable vehicle through which a debtor can negotiate a feasible plan of reorganization. In many Chapter XI cases, the Official Committee is composed of those interested parties which functioned as an unofficial committee of creditors prior to the filing of the Chapter XI petition. While the Commission Bill does not preclude an Administrator from appointing as an Official Committee the members of the unofficial committee, Section 7-101 implies that the Official Committee be composed of creditors holding "the largest amount of unsecured claims against the debtor who are representatives of the different types, if any, of the creditors having claims against the debtor." This language appears susceptible to the Interpretation that a Chapter VII debtor with $100 million of liabilities, including $90 million of bank debt, $5 million in subordinated debt, $3 million in public senior debt, $1 million in trade debt, $2 million in wage claims and $2 million in landlord claims will have an Official Committee which includes the largest bank claimant, senior debentureholder, subordinated debentureholder, trade creditor, wage claimant and landlord. 7 Such a committee would not reflect the economic interests of creditors and would, in most cases, be incapable of negotiating a plan with a debtor or trustee. 3. Use of Collateral. In certain cases it may be appropriate to enjoin a secured creditor from foreclosing its lien upon property of the debtor. Where such property is essential to the continued operation of the debtor (i.e. a plant or equipment) and provided that the debtor sustains its twin burden of proving that there is a reasonable likelihood of successful reorganization and that the secured creditor is adequately protected, the balancing of the creditor's interest in his collateral against the debtor's right to a "second chance" may well favor the debtor. However, Section 7-203 of the Commission Bill, as drafted, does not distinguish between a debtor's use of fixed assets whose values may be preserved by preventing the liquidation of the debtor's business and the debtor's use of inventory, receivables, and cash collateral which may easily be consumed by a debtor operating with a negative cash flow. A debtor should not be permitted to use perishable collateral, or the proceeds thereof, in its business without notice to the secured creditors, and a hearing at which time the debtor must sustain the burden, as articulated in In re Third Ave. Transit Corp., 198 F.2d 703 (2d Cir. 1952), of proving by the clearest evidence (i) that the use of the property subject to lien is imperative, (ii) that there is a high degree of likelihood that the debtor can be reorganized within a reasonable time and (iii) that the secured creditor whose security is being compulsorily loaned will not be injured. By shifting the burden to the creditor under Section 7-203(b) to come forward and stop a debtor from dissipating the creditor's collateral, this provision is, in our view, certainly unfair and perhaps unconstitutional. We also want to note our opposition to subsection (a)(2) which endeavors to repeal Section 9-204(3) of the Uniform Commercial Code and deprive a secured creditor of the proceeds of his pre-petition collateral. It is our position that Section 7-203 should be redrafted along the lines suggested by Patrick A. Murphy in his article entitled "Use of Collateral in Business Rehabilitations; a Suggested Redraft of Section 7-203 of the Bankruptcy Reform Act", which appears at 63 Cal.L.Rev. 1483 (1975). 4. Setoff. Section 7-204 of the Commission Bill poses problems similar to those posed by Section 7-203. While any incursion upon a commercial bank's right to setoff deposits against outstanding loans is objectionable to lending institutions, Section 7-204 is particularly objectionable insofar as it does not provide specific standards against which a court may determine whether the trustee or the debtor can furnish such protection as will adequately protect the person asserting the right of setoff. If a court may order a bank to pay over amounts owed by the bank to the debtor which are subject to a claim of setoff, the trustee or the debtor should be required to satisfy the same burden of proof as has been previously suggested as the condition precedent to the use of property subject to a lien. Since cash in the hands of a financially troubled debtor may be a far more perishable commodity than any of the other forms of personal property subject to a lien, it is essential that a trustee or debtor satisfy a significant burden of proof before a bank is forced to pay over funds to the debtor or trustee. 5. Incurrence of Indebtedness by Debtor or Trustee. While we recognize that in a proper case it may be both beneficial and necessary to permit the debtor or trustee to borrow funds in order to carry on the debtor's business, a debtor or trustee should not be allowed to incur obligations secured by a superpriority lien on encumbered property without the debtor or trustee satisfying the same burden of proof which would be required in order to permit a debtor to use perishable collateral subject to a lien or funds held subject to the right of setoff. A debtor or trustee should be permitted to incur obligations subject to a superpriority lien only after a hearing held on notice to affected creditors and only after the trustee or debtor has sustained the burden of proving (i) that funds are otherwise not available, (ii) that there is a demonstrable likelihood that the debtor can be reorganized within a reasonable period of time, and (iii) that the secured creditors are adequately protected. Cf. In re Third Ave. Transit Corp., supra. 6. Voidable Preferences. Section 4-607(f) changes existing law by creating a presumption of insolvency with respect to a debtor throughout the three-month period prior to the date of filing of a petition. The effect of the section is to shift to a creditor the burden of proving the solvency of the debtor at the time of receipt of a transfer within the three month period prior to the filing of the petition. Given the exceptions provided in Section 4-607(b), (c), and (d), the effect of this provision is to unfairly prejudice the position of a commercial lender making loans on an unsecured basis. Under existing law, in order to avoid a preferential transfer, as defined in Section 60(a) of the Bankruptcy Act, the debtor or trustee must demonstrate both the insolvency-in-fact of the debtor and facts sufficient to prove that the creditor, receiving the transfer, had reasonable cause to believe that the debtor was insolvent at the time the transfer was received. In our view it is patently unfair to prejudice a commercial lender who receives a transfer within three months, in good faith, without knowledge of, or reason to believe that, the debtor is insolvent. We would respectfully request the opportunity to present to this Committee a proposed redraft of Section 4.607. Conclusion As I have stated earlier, the economic impact particularly as it effects commercial banks' lending of enactment of either of the proposed bills without the modifications which we have requested would be serious. Most debtors which enter into rehabilitation proceedings can be permitted to fail without making a significant impact on the economy of the nation or any region. The burden must be on those proposing interference with rights of creditors to justify this interference. Significant erosion of creditors' rights will increase the cost and decrease the availability of funds to American businesses, particularly those enterprises which are introducing new products or processes to the marketplace-just the type of enterprises which are essential to the continued economic growth of our nation. In closing I would like to indicate that the problem areas I have mentioned are not the only ones present in the bills but are merely indicative of what we believe to be the absence of evaluation of the proposals from the viewpoint of the capital markets. We have not specifically addressed problems such as the definition of "affiliate" as set forth in Section 1-102(4), or the effect of the "net result" rule as set forth in Section 5-201(b) which shall be the subject of our written submission to the Committee. On behalf of the Robert Morris Associates, I would like to thank the Committee for affording us the opportunity to present these thoughts on the pending bills. FIGURE I The Number of Business Failures is Currently Below That of the Early 1960's, and Continues to Conform to the Business Cycle SOURCE: DUN AND BRADSTREET, INC.; BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM FIGURE 2 The Ratio of Business Failures to New Incorporations Has Dropped Over the Past Eighteen Years, Reflecting the Fact That the U.S. Economic Environment Still Favors the Growth of Business Formation. 30 30 SOURCES: DUN AND BRADSTREET, INC.; DEPARTMENT OF COMMERCE, BUREAU OF ECONOMIC ANALYSIS NUMBER OF FAILURES |