Businesses facing financial difficulties that want to restructure their debts and continue operations must do so under Chapter 11 of the Bankruptcy Code. However, some elements of Chapter 11 made it difficult for small businesses to reorganize effectively.
In particular, the Absolute Priority Rule imposed a significant barrier to successful reorganizations. Under that provision of the Bankruptcy Code, the owner(s) of a business cannot keep their equity unless they either pay all creditors in full or provided a capital injection to essentially purchase their equity (termed “new value”). Having to pay all creditors in full was simply not feasible for many small businesses. Furthermore, by the time small businesses seek bankruptcy protection, they’ve often tapped out all available sources of additional capital, so they had no source of funds with which to provide new value.
Additionally, the requirement that all administrative claims be paid on the Effective Date of the plan of reorganization created a significant hurdle. Administrative claims are the obligations incurred during the course of the bankruptcy that were necessary either to keep the business operating (i.e., if the business was ordering necessary supplies or services) or to complete the bankruptcy case (including the costs of professionals like lawyers and accountants). In particular, the requirement that all attorneys’ fees be paid on the Effective Date of the plan of reorganization was difficult for many small businesses and left less cash to be distributed to pre-petition creditors.
Finally, the Chapter 11 process is, by its nature, too long and too expensive for small businesses without access to substantial debtor-in-possession financing. The prospect of a year-long bankruptcy case with multiple stages that could include contested hearings is more often a death knell for a small business rather than a beacon of hope for a small business.
Small Business Reorganization Act (“SBRA”)
In February 2020, the Small Business Reorganization Act (“SBRA”) went into effect, bringing some dramatic changes to the Chapter 11 bankruptcy process for small businesses. The law is codified at subchapter V of Chapter 11 of the Bankruptcy Code and the small business cases are sometimes called subchapter V cases. The purpose of the legislation was to remove some of the impediments in the Bankruptcy Code that prevented smaller businesses from being able to successfully confirm plans of reorganization and to make the process faster and more efficient for smaller bankruptcy cases.
First, to be eligible to file under the SBRA, the debtor must qualify as a “small business debtor” which means that it has non-contingent, liquidated debts of less than $2.75 million, at least half of which arose from the debtor’s business or commercial activities. Under the recently-passed CARES Act, for one year the debt limit is increased to $7.5 million.
Immediately upon the filing of the bankruptcy case, the Office of the United States Trustee will appoint a subchapter V trustee. The subchapter V trustee is a neutral party whose primary concern is to monitor the debtor’s progress through the bankruptcy case and facilitate discussions with creditors in hopes of achieving a consensual plan of reorganization.
There are fairly short deadlines for many of the major requirements in a subchapter V case. The First Meeting of Creditors is held very promptly and a scheduling conference will be set by the Bankruptcy Court within 60 days of the case being filed. The debtor’s proposed plan of reorganization has to be filed within 90 days of the entry of an order for relief. (In a voluntary bankruptcy, the Petition is the order for relief. In an involuntary bankruptcy, the Court enters an order allowing the Petition, which triggers this 90-day deadline.)
In a subchapter V case, there are fewer requirements for a plan of reorganization. For example, the owner(s) of the business can retain their equity even if the plan does not comply with the Absolute Priority Rule. While the goal of a subchapter V case is to negotiate a consensual plan that is acceptable to the creditors and feasible for the debtor, the debtor has greater ability to “cram down” a nonconsensual plan compared to a traditional reorganization case. The Bankruptcy Code seems to contemplate that small business debtors will make payments to their creditors in 3-5 years, although those terms are not mandated.
In a typical Chapter 11 case, the debtor does not receive a discharge unless and until it pays all its creditors in full (in which case, the discharge is a mere formality since there is no outstanding debt for any creditor to collect), but in a subchapter V case, the debtor can receive a discharge in as little as 3 years if it makes all its payments under the plan of reorganization.
The Administrative Claims of professionals, i.e., the fees charged by bankruptcy counsel, can be paid out during the term of the plan of reorganization rather than being paid in full on the Effective Date.
By making business bankruptcy simpler, faster, and less expensive for small businesses, it is hoped that more small businesses will be able to benefit from the protections of the bankruptcy code and remain operating.
Guest post by Natalie Wilson
Natalie Wilson is a shareholder in the San Antonio, Texas office of Langley & Banack, Inc. She has over a decade of experience representing debtors, creditors, and trustees in business bankruptcy cases, including related litigation and appeals. She is Board Certified in Business Bankruptcy Law by the Texas Board of Legal Specialization.
She can be reached at:
Phone: (210) 736-6600