Big Changes to Small Business Bankruptcies: Timely Amendments to The Bankruptcy Code Throw A Lifeline to Small Businesses Struggling to Stay Afloat Amid the COVID-19 Crisis
The Small Business Reorganization Act (“SBRA”), which became effective February 19, 2020 after being signed into law in August 2019, created a new Subchapter V of Chapter 11 of the Bankruptcy Code with a stated purpose “to streamline the process by which small business debtors reorganize and rehabilitate their financial affairs.” The SBRA amendments fill a previous gap in the Bankruptcy Code and now provide a viable and cost-efficient reorganization option for small businesses.
Before SBRA, struggling businesses considering bankruptcy had only two options: chapter 7 or chapter 11. Chapter 11 is designed for the restructuring of companies with a reasonable prospect of ongoing business while liquidation under chapter 7 results in the shuttering of the company and the sale of its assets for the benefit of creditors. However, for smaller companies, the high costs and complexities of chapter 11, even under the small business provisions enacted with the Bankruptcy Abuse and Consumer Protection Act of 2005 (“BAPCPA”), all too often made it too difficult and expensive for small businesses to utilize the provisions of the Bankruptcy Code to reorganize. Subchapter V retains some of the small business components of BAPCPA while adding new features designed to make chapter 11 more accessible to small businesses. SBRA does not repeal existing provisions that govern small business debtors in chapter 11. These provisions continue to apply to small business debtors who do not affirmatively elect to proceed under Subchapter V.
Subchapter V enables small business debtors to file bankruptcy in a timely, cost-effective manner that hopefully allows them to remain in business for the benefit of owners, employees, trade vendors, customers and others who rely on the business.
Through the end of October 2020, approximately 1,000 Subchapter V cases have been filed nationwide. The rate of filings is only expected to intensify in the upcoming months as the beneficial effects of the Paycheck Protection Program stimulus funds wear off and troubled businesses seek to take advantage of the expanded eligibility limits of Subchapter V before they are scheduled to expire in March 2021.
COMMENCING A CASE UNDER SUBCHAPTER V
Election and Eligibility for Subchapter V. An eligible debtor must affirmatively elect Subchapter V in its petition or the case will proceed as a traditional chapter 11. Upon filing, the debtor must file a balance sheet, statement of operations, a cash flow statement and federal tax returns.
To be eligible for Subchapter V, an individual or business debtor must be engaged in a commercial activity with total debts of less than $2,725,625. In response to the COVID-19 pandemic, the Coronavirus Aid and Economic Security Act (“CARES”) temporarily amended SBRA to increase the debt eligibility ceiling for Subchapter V to $7.5 million for a one-year period currently scheduled to expire on March 27, 2021. This increase of the debt eligibility limits enables larger companies to take advantage of the fast and efficient provisions of SBRA during the current economic crisis.
Debtor in Possession. Under normal circumstances, a Subchapter V debtor remains in control of the operation and management of its business as well as the assets of the estate. However, the bankruptcy court may remove the debtor from possession of estate assets for cause — including fraud, dishonesty, incompetence, or gross mismanagement.
Appointment of Subchapter V Trustee. In a chapter 7 bankruptcy case, a trustee is appointed to take possession of and liquidate the debtor’s assets for the benefit of its creditors. A trustee is rarely appointed in a chapter 11 case and is done so only upon a showing of cause such as fraud or mismanagement by the debtor’s principals. In contrast, a trustee is automatically appointed in all Subchapter V cases and is tasked with the duties to supervise and monitor the case and to “facilitate the development of a consensual plan of reorganization.” The statutory emphasis favoring consensual plans suggests that the Subchapter V trustee will fill a mediation role and will be proactive in the plan process.
Additionally, upon request of a party in interest and for cause, the bankruptcy court may order the Subchapter V trustee to perform certain duties of a chapter 11 trustee, including (i) investigating the acts, conduct, assets, liabilities and financial condition of the debtor, the operation of its business, the desirability of its continuance, and any other matter relevant to the formulation of a plan; (ii) filing a statement of the investigation, including findings of fraud, mismanagement or other misconduct; and (iii) filing post-confirmation reports as the court directs.
However, the bankruptcy court may remove the debtor as debtor in possession and, in such event, the Subchapter V trustee has the duties to be accountable for all property received, examine and object to proofs of claim, oppose discharge; to furnish information about the estate and its administration upon request of a party in interest; and to make and file a final report.
CASE ADMINISTRATION AND PROCEDURES
Subchapter V includes a number of features designed to facilitate the efficient and inexpensive administration of the case and the prompt confirmation of a plan that modify the usual procedures in chapter 11 cases in several important ways.
Elimination of the Committee of Unsecured Creditors. In many medium and larger Chapter 11 business cases, the United States Trustee appoints a committee of unsecured creditors, consisting of 5 to 7 of the largest unsecured creditors, who act to advance the interests of all unsecured creditors in the case. The unsecured creditors’ committee hires its own counsel, whose costs and fees are paid as administrative expenses by the estate. In contrast, and except when ordered by the court for cause, creditors’ committees are not formed in Subchapter V, which not only spares the estate of considerable expense but avoids the often adversarial nature of such committees which may impede the reorganization process.
Status Conference and Debtor Report. In an effort to reduce the duration and administrative costs of reorganization, Subchapter V demands rapid advancement to plan confirmation. A status conference is held by the court within 60 days of filing “to further the expeditious and economical resolution” of the case. At least 14 days prior to that conference, the debtor must submit a written report of the efforts made towards obtaining a consensual plan.
Elimination of the Disclosure Statement and a Quick Path to Plan Solicitation and Confirmation. Unlike a typical chapter 11, where creditors have the ability to file competing plans after the debtor’s period of exclusivity expires, the Subchapter V debtor has the exclusive right to file a plan of reorganization and must do so with 90 days of filing. This compares with the 300-day plan filing requirement of a typical chapter 11.
A typical chapter 11 debtor must prepare and obtain approval of a separate disclosure statement prior to solicitation of a plan and only has the benefit of a limited period where it has the exclusive right to propose a plan before creditors may seek approval of competing plans. Subchapter V, in contrast, eliminates the requirement of a disclosure statement requirement —making plan solicitation and confirmation a one-step process.
Modified Plan Confirmation Requirements. While there is a statutory emphasis towards formulating consensual plans, confirmation of a plan under Subchapter V does not require acceptance by creditors. The bankruptcy court may confirm such a plan if it determines that it does not “discriminate unfairly” and is “fair and equitable.” Creditors must be paid at least as much as they would receive on their claims if the debtor were in a chapter 7 liquidation. There are three new provisions governing the content of a plan.
- First, while no disclosure statement is required and there is no requirement that the plan contain “adequate information” as in a typical Chapter 11, the Subchapter V plan must include a brief history of the debtor’s business operation, a liquidation analysis, and projections regarding the debtor’s ability of make payments under the proposed plan.
- Second, Subchapter V requires the debtor to contribute all its “projected disposable income” into the plan for a period of three to five years. Projected disposable income consists of what remains after expenses to maintain and support the debtor and expenses necessary for business operations.
- Third, the rule prohibiting the plan modification of the rights of a claim secured only by an interest in the debtor’s principal residence found in chapter 13 has been changed. Such modification is permitted in Subchapter V if the new value received in connection with the granting of the security interest was “not used primarily to acquire the real property” and was “used primarily in connection with the small business of the debtor.”
The bankruptcy court must find that the plan is feasible and that there is a reasonable likelihood that the debtor will be able to make the payments provided for under the plan.
Deferred Payment of Administrative Claims. Administrative expenses are defined as goods and services that benefit administration of the estate and consist of such things as professional expenses of the estate, priority claims for purchased goods received by the debtor within 20 days before the petition date, post-petition claims of lessors of non-residential real property and other post-petition goods and services obtained by the debtor in the operation of its business.
In a typical Chapter 11 case, administrative expenses must be paid in full by the effective date of the plan. In some instances, the aggregate amount of administrative claims exceeds the ability of the debtor to immediately pay in full preventing the confirmation of the plan. In an effort to remove this barrier to successful reorganization, Subchapter V gives the small business debtor the flexibility to pay administrative claims over the life of the plan.
Absolute Priority Rule Does Not Apply. In a typical Chapter 11 case, the absolute priority rule prohibits the debtor from retaining its equity interests in the business unless senior classes of creditors are either paid in full or vote to accept the plan. Among the more attractive features of SBRA, the absolute priority rule does not apply in a Subchapter V case so a debtor may retain its equity in the business even though creditors are not paid in full provided the plan does not “discriminate unfairly” and is “fair and equitable.”
Bar Date for Filing Proof of Claim. The Bankruptcy Rules governing the deadlines for filing proofs of claim in chapter 11 cases apply in Subchapter V. This rule provides that the court “shall fix and may extend the time within which proofs of claim or interest may be filed.” Some courts have adopted procedures for fixing the bar date at the onset of the case, including the deadline in the Notice of Chapter 11 Bankruptcy Case issued by the clerk. Others will include the deadline in a separate document. To the extent that local practice leaves it to counsel to request the setting of a claims bar date, 70 days after the petition date is widely recognized as appropriate claims bar date since it falls before the 90-day deadline for the debtor to file a Subchapter V plan.
Modification of the Disinterestedness Requirement for Debtor’s Professionals. In a typical chapter 11 case, a debtor is prohibited from employing professionals that are not “disinterested” with interests “materially adverse to the interests of the estate.” In real world practice, many attorneys who provide representation to a debtor prior to a bankruptcy filing are owed unpaid fees or have received payments prior to the filing that might be avoidable as preferences. Such professionals must either waive or repay such fees to the estate or forego representation altogether. The provisions of Subchapter V address this problem by not requiring disqualification solely because the professional holds a prepetition claim of less than $10,000.
Discharge and Distribution. Under a consensual plan, a Subchapter V debtor (including an individual debtor) receives a discharge of debts upon confirmation. Under a non-consensual, cramdown plan, the debtor receives a deferred discharge upon the successful completion of plan payments.
When the court confirms a consensual plan, the Subchapter V trustee’s service terminates upon substantial consummation, which ordinarily occurs with the commencement of plan distributions. Under a cramdown plan, the trustee bears the responsibility of collecting plan payments from the debtor and making distributions to creditors for the duration of the plan and, as such, the Subchapter V trustee service does not terminate in a cramdown plan until the plan is complete.
SBRA provides small businesses and individuals with a viable path to reorganization under Chapter 11, offering a number of advantages over a conventional Chapter 11 business bankruptcy. Enacted and becoming effective just prior to the COVID-19 crisis, SBRA fills a critical void in the Bankruptcy Code and clears the way for small businesses to efficiently reorganize and remain in control of their business during these troubled times. The use of SBRA as an effective tool for reorganization is expected to only increase over the next several months as the economic impact of COVID-19 intensifies, the beneficial effects of the CARES stimulus wanes, and larger-sized debtors rush to take advantage of the expanded debt limits of Subchapter V before the scheduled reversion in March 2021.
The information contained in this publication should not be construed as legal advice, is not a substitute for legal counsel, and should not be relied on as such. For legal advice or answers to specific questions, please contact one of our attorneys.