Many business owners, large and small, are now facing cash challenges. Perhaps the word “bankruptcy” has even been uttered. While work-outs and financial restructuring are more often the preferred options, the CARES Act includes modifications to the eligibility of small businesses for a simplified bankruptcy reorganization procedure which may make more permanent solutions appealing.
Most business owners have heard of “Chapter 11,” a chapter of the United States Bankruptcy Code ostensibly allowing debtors to “reorganize” or restructure their debts. Entering Chapter 11 does not mean the death of a business—unlike a Chapter 7 proceeding which terminates and liquidates the business—but instead allows businesses to “breathe,” take a break from collection actions, shed debt and unwanted contracts, and hopefully emerge from bankruptcy a leaner and stronger company. The automatic stay created by a bankruptcy filing, for example, will enjoin landlords from proceeding with evictions and will stop collection actions, at least temporarily.[1] The Chapter 11 debtor continues to operate its business and pay its employees, including the payment of reasonable compensation to owners that work in the business. Upon exiting from Chapter 11 pursuant to a “plan of reorganization” approved by creditors and the bankruptcy court, the debtor will pay its pre-bankruptcy creditors over time, often in an amount much less than initially owed. However, unless the owners of the debtor can fund the Chapter 11 plan from their own resources, they generally stand to lose control of, and a significant portion of their equity in, their businesses, as under the “absolute priority rule” in bankruptcy creditors are entitled to be paid before equity holders receive any distribution.
Until recently, the administrative costs of Chapter 11 bankruptcy eliminated it as a viable option for many small businesses. But in 2019, Congress passed the Small Business Reorganization Act of 2019 (“SBRA”) which streamlines Chapter 11 bankruptcy for qualifying small businesses and greatly reduces its administrative costs. The new Bankruptcy Code provisions in the SBRA, referred to as Subchapter V of Chapter 11, were passed before the full impact of social distancing and the economic slowdown caused by COVID-19, but the virus certainly has enhanced the importance of the new law. Further, as part of the CARES Act, enacted in response to COVID-19, Congress did make a critical change to this law; it redefined a “small business,” making the SBRA applicable to a far greater pool of potential candidates. Originally, a business qualified for Subchapter V small business reorganization only if its qualifying aggregate debts were less than $2,725,625. The CARES Act temporarily increases the limit to $7,500,000 for one year from the date of the Act (March 25, 2020).
As the owner of a small or medium size business these new laws provide for a possible viable option if your business cannot pay its debts. For creditors, Subchapter V will be something of a brave new world in terms of how it may alter the leverage of creditors when negotiating work outs and in Chapter 11 bankruptcy negotiations.
Does my business qualify for a small business reorganization in Chapter 11?
It is important to note that a business does not have to be insolvent, in the sense of the value of its liabilities exceeding the value of its assets, in order to seek Chapter 11 relief. See 11 U.S.C. § 109 (d). Rather, a “good faith” basis is needed. See Platinum Capital, Inc. v. Sylmar Plaza, L.P. (In re Sylmar Plaza, L.P.), 314 F.3d 1070, 1075 (9th Cir. 2002).
To seek Chapter 11 relief, the entity filing the bankruptcy petition must be a “person,” meaning an individual, partnership, or corporation. See 11 U.S.C. §§ 101 (41), 109 (d). To qualify for a small business reorganization, a person must: (a) be engaged in commercial or business activities and (b) have aggregate noncontingent liquidated secured and unsecured debt, of not more than $7,500,000[2] (excluding debts owed to affiliates or insiders), not less than half of which arose from the commercial or business activities of the debtor. See 11 U.S.C. § 101 (51D).
Once the bankruptcy petition is filed, the business becomes known as the “debtor,” or “debtor in possession.” See 11 U.S.C. § 1182. The debtor in possession will then operate the business in bankruptcy and has the right to propose a plan of reorganization in order to emerge from bankruptcy. See 11 U.S.C. § 1184.
How does SBRA simplify the reorganization process?
The SBRA is designed to decrease the cost and complexity of reorganization. In a traditional Chapter 11 case, the debtor must pay quarterly fees to the United States Trustee, an office of the Department of Justice which monitors—and often plays an active role in—Chapter 11 cases. See 28 U.S.C. § 1930 (a) (6). The quarterly fee depends on the quarterly disbursements of the debtor, and ranges from $325 in the smallest cases to $250,000 in the largest ones. See Department of Justice – Chapter 11 Quarterly Fees, available at https://www.justice.gov/ust/chapter-11-quarterly-fees (last accessed 4/6/20). The SBRA eliminates these quarterly fees for small business bankruptcies. See 28 U.S.C. § 1930 (a) (6) (a).[3]
An important aspect of Subchapter V is the use of a standing trustee to assist in the management of the bankruptcy case. See 11 U.S.C. § 1183 (a). In many ways, the standing trustee will ease the debtor’s burden, in that he or she will be accountable for property received by the bankruptcy estate, examine and object to proofs of claim (meaning claims by creditors for payment by the estate), facilitate the development of a consensual plan of reorganization, and make a final report and account of the administration of the estate. See 11 U.S.C. § 1183 (b) (1), (7). The standing trustee will also serve a supervisory and investigative role, and will be empowered to investigate the acts and assets of the debtor, appear at court hearings, and ensure that the debtor makes payments towards the confirmed plan of reorganization. See 11 U.S.C. § 1183 (b) (2)–(4). She/he will be compensated for her or his services in the debtor’s plan of reorganization. See 28 U.S.C. § 586 (e) (2).
Subchapter V also modifies the process of confirming a plan of reorganization. A plan of reorganization spells out which creditors will be paid and how much they will be paid. See 11 U.S.C. § 1123 (a).[4] The plan of reorganization separates creditors into categories (classes)—grouped by the similarity of their claims—and then specifies how each class will be treated, i.e., how much members of the class will be paid on their claims. See 11 U.S.C. §§ 1122, 1123 (a) (1). The creditors will then get the chance to accept” or reject the plan of reorganization, and their votes will determine whether the plan may be “confirmed” (approved) by the bankruptcy court. See 11 U.S.C. §§ 1126, 1129 (a) (8).
Subchapter V helps to “clear the path” in several ways. First, and as discussed above, it contemplates appointment of a standing trustee to work with the debtor and creditors to arrive at a consensual plan. See 11 U.S.C. § 1183 (b) (7). Second, it generally eliminates the committee of unsecured creditors, which in a traditional case has broad powers to investigate the debtor’s management of the estate and to recommend to creditors whether to support confirmation of a plan of reorganization. See 11 U.S.C. §§ 1181 (b) (eliminating committees unless “good cause” shown to the court); see also 11 U.S.C. §§ 1102, 1103 (describing committees and their powers). Third, the SBRA eliminates the requirement that a debtor file a disclosure statement—a detailed explanation of the debtor’s finances, roughly analogous to a securities prospectus, serving to educate creditors in advance of voting on the plan of reorganization—and instead broadens the information required in the plan of reorganization itself. See 11 U.S.C. §§ 1181 (b), 1190; see also 11 U.S.C. § 1125.
Fourth—and significantly— Subchapter V modifies the absolute priority rule, so that the owners of the business may in certain circumstances keep their equity interests in the business even if a senior class of claims is not paid in full by the plan of reorganization, so long as all of the debtor’s “disposable income” is paid to creditors over a three to five year period (similar to the requirements of a Chapter 13 plan for individuals). See 11 U.S.C. § 1129 (b) (2) (C). Fifth, and just as significant, whereas in most traditional Chapter 11 cases all classes of creditors must vote to accept a plan of reorganization in order for the plan to be confirmed, the SBRA provides that the plan of reorganization may be confirmed even if rejected by an impaired class of creditors, provided that it does not discriminate unfairly and is fair and equitable to that that class of creditors. See 11 U.S.C. § 1191 (b). We anticipate that these changes will enable the standing trustee and debtor to effectively negotiate consensual plans with much reduced admirative cost to the business.
Conclusion
If you are considering your business’s options in dealing with financial issues resulting from the coronavirus pandemic and the economic slowdown, seek competent legal counsel to see if an out of court work out or other restructuring with creditors is available. Bankruptcy should not be the first option. However, it may be another viable tool to help you save your business in times like these. And the recent CARES Act modifications may make it a better option than many considered just one month ago.
If you would like more information, please contact a member of our Business Restructuring and Creditors’ Rights team.
[1] It bears noting that creditors in certain circumstances can obtain relief from the stay by filing a motion with the bankruptcy court. See 11 U.S.C. § 362 (d).
[2] As amended by the CARES Act increases the limit from $2,725,625 to $7,500,000. See CARES Act § 1113. This increase, however, sunsets after one year. See id.
[3] The “standing trustee” will be still be compensated (more on this below).
[4] The debtor is generally required to file a proposed plan within 90 days of filing, but the Court can extend that deadline “if the need for the extension is attributable to circumstances for which the debtor should not justly be held accountable.” 11 U.S.C § 1189 (b). This is an important provision in the present environment. It is, after all, hard to plan out the future ability of debtor to pay its debts when the business remains closed due to the Coronavirus. It is expected that Courts will grant extensions readily for the immediate future.