Small Business Bankruptcies: Subchapter V isn’t just for the Smallest Businesses

by | Aug 18, 2020

The CARES ACT Expands Eligibility For Subchapter V Providing More Businesses a Viable Option to Reorganize. 

Earlier this year, the Small Business Reorganization Act of 2019, which created the new Subchapter V of the Bankruptcy Code (11 U.S.C. §§ 1181-1195 “Subchapter V”), went into to effect.  The intent of the new Subchapter was to offer small businesses a better chance to reorganize under the Bankruptcy Code through a streamlined and cost-effective process.  Traditional Chapter 11 cases were often seen as too expensive, time consuming and unpredictable for smaller business debtors.   Subchapter V seeks to simplify the reorganization process by eliminating some of the large expenses of a Chapter 11 Bankruptcy case, including funding a creditors’ committees and certain United States Trustee fees, while also speeding up the process by requiring a reorganization plan to be filed within 90 days of the bankruptcy filing and eliminating the requirement to file a disclosure statement.  Subchapter V also provides small business owners a better opportunity to retain ownership of their business through the reorganization process by eliminating  the “absolute priority” rule (owners can retain their equity in a Subchapter V small business over the objection of a class of unsecured creditors, without paying those creditors in full).

As originally enacted, only small business debtors with up to $2,725,625 in secured and unsecured non-contingent liquidated debt were eligible to elect to reorganize under Subchapter V.   Shortly after Subchapter V became effective, in response to the Covid-19 crises and as part of the Coronavirus Aid, Relief and Economic Security (CARES) Act, Congress temporarily expanded the debt cap for businesses to reorganize under Subchapter V to $7,500,000 in secured and unsecured non-contingent liquidated debt.  The expanded debt cap will enable more struggling businesses to take advantage of the debtor friendly provisions of Subchapter V while the economy recovers from the economic fallout from the pandemic. 

Who is Eligible To Reorganize Under Subchapter V

To be eligible to reorganize under Subchapter V of the Bankruptcy Code, a debtor must first satisfy the eligibility requirements and elect to be a Subchapter V debtor.  With its CARES Act amendment, Bankruptcy Code Section 1182 defines a debtor eligible for Subchapter V as a person or business:

engaged in commercial or business activities (including any affiliate of such person that is also a debtor under this title and excluding a person whose primary activity is the business of owning single asset real estate) that has aggregate noncontingent liquidated secured and unsecured debts as of the date of the filing of the petition or the date of the order for relief in an amount not more than $7,500,000 (excluding debts owed to 1 or more affiliates or insiders) not less than 50 percent of which arose from the commercial or business activities of the debtor.

Of note, a debtor that is (i) a member of a group of affiliated debtors that has aggregate noncontingent liquidated secured and unsecured debts in an amount greater than $7,500,000 (excluding debt owed to 1 or more affiliates or insiders); (ii) a corporation subject to the reporting requirements under section 13 or 15(d) of the Securities Exchange Act of 1934 or (iii) an affiliate of an issuer, as defined in section 3 of the Securities Exchange Act of 1934, is not eligible for Subchapter V.   

In determining eligibility of a debtor for Subchapter V, debts that are contingent (such as a claim based on a guarantee of a third-party debt) or unliquidated (such as a tort claim) are not included.  Thus, in theory, a larger business that has reduced its liquidated non-contingent debts bellow $7.5 million, but is facing significant amounts of contingent or unliquidated litigation claims might be able to squeeze their case into Subchapter V despite potentially large contingent claims.

The Small Business Trustee

Unlike a typical Chapter 11 case, Subchapter V requires that the United States Trustee appoint a disinterested person to serve as the trustee for the Subchapter V case.  Distinct from trustees in Chapter 7 cases, the Subchapter V trustee does not take possession of the debtor’s assets or operate the debtor’s business.  Rather, the Subchapter V trustee takes on a role more similar to that of a Chapter 13 trustee in a consumer bankruptcy case.    The trustee in these cases will ensure the debtor commences payments under its plan, investigate the financial affairs of the debtor and object to the allowance of proofs of claim.  The Subchapter V trustee is also expected to “facilitate the development of a consensual plan of reorganization.”  See 11 U.S.C. § 1183.  In addition, if the court removes a debtor from its role as a debtor-in-possession, the trustee will take control of the debtor’s assets and operate the debtor’s business. 

Streamlined Chapter 11 Reorganization

A significant advantage for a debtor proceeding under Subchapter V is that it offers a significantly streamlined, relatively quick and cost-effective reorganization process.  First, committees of unsecured creditors are not formed in Subchapter V cases unless the court for cause orders otherwise.    Thus, the expense to the debtor’s estate of a creditors’ committee together with its counsel and other advisors will be eliminated.

Second, Subchapter V provides for a shortened timeframe to file and confirm a plan. The plan of reorganization must be filed within ninety days of the commencement of the case and may only be extended if the court finds that “the need for an extension is attributable to circumstances for which the debtor should not justly be held accountable.”   Also, only the debtor may file a plan of reorganization.  By compressing the case timelines, limiting opportunities to extend the deadlines, and only allowing debtors to file plans, debtors can more efficiently and economically reorganize their businesses. 

Third, there is no requirement that the debtor file a disclosure statement in connection with its plan of reorganization unless the Court order otherwise.   In a standard Chapter 11 case, a debtor must file a hefty disclosure statement that lays out the terms of the plan, describes the debtor’s operating history, its assets, debts, and includes a liquidation analysis.  This disclosure statement must be approved by the court and circulated to all creditors.  Subchapter V does away with this expensive, laborious and time-consuming process, instead requiring that the Debtor’s plan include a brief history of the business operations of the debtor, a liquidation analysis, and projections with respect to the debtor’s ability to make payments under the proposed plan.

The downside to this streamlined process is that the debtor will have little time to stabilize its business under bankruptcy protection while working out a plan to reorganize.  Under Subchapter V, the debtor must work quickly to formulate and present a plan.  Small businesses would be wise to consider reorganization options and plans before filing for relief. 

Owners Are More Likely To Retain Control Over the Reorganized Debtor

Perhaps the most significant advantage of a Subchapter V bankruptcy is that equity owners have a better chance to retain control of the reorganized business.  In a typical bankruptcy case, existing owners cannot retain equity in the debtor business over the objection of a class of unsecured creditors, unless the class is paid in full or the owners contribute new capital into the company.  In other words, in order to “cram down” a plan on a class of creditors and retain ownership, those creditors must be paid in full or accept the plan.  This rule, called the “absolute priority rule”, does not apply in Subchapter V bankruptcy cases. 

Rather, as long as unsecured creditors receive a distribution of the debtor’s “disposable income” for a period of three years (or up to five years if extended by the court), equity holders may retain the equity in the debtor and continue to manage the debtor’s business, even where creditors do not vote to accept the plan and object to confirmation.  As long as the plan “does not discriminate unfairly” and is “fair and equitable” with respect to impaired unsecured creditors, the court shall confirm the plan.  In fact, the debtor does not need to obtain the acceptance of any impaired class of creditors.

The available options and flexibility for equity owners to retain ownership of their businesses through the reorganization process is a significant incentive to proceed under Subchapter V.  In small business cases, giving up the equity is usually not a viable option because owners of small businesses are often the only managers willing or able to run the business.  In addition, business owners might not be willing or able to invest the resources needed to fund a bankruptcy case and then risk losing the business anyway if unsecured creditors are not paid in full and object.  Many owners will just walk away, and the business, and its jobs, will be lost to the community.

Many Creditor Protections Remain Intact

Notwithstanding the many debtor friendly provisions in Subchapter V, most of the key creditor protections of the Bankruptcy Code remain in place.  First, in order to confirm a plan over the objection of a secured creditor, the debtor’s plan must provide either (i) that the holder of the secured claim retain its lien and receive deferred cash payments equal to the value of its collateral, or (ii) for the sale of the creditor’s collateral free and clear of the creditor’s lien with such lies to attach to the proceeds of sale, subject to the right of the secured creditor to credit bid for its collateral.

Second, prior to the time for plan confirmation, secured creditors also retain the right to demand adequate protection against the diminution in the value of their collateral.  This could include regular payments or additional liens.  Creditors also retain their right to seek relief from the automatic stay in order to realize the value of their collateral.

While unsecured creditors lose the protection of the “absolute priority rule” in a plan confirmed under Subchapter V, they retain the protection of the “best interests of creditors test”.  That test requires that creditors receive at least as much under a plan of reorganization as they would receive if the debtor were liquidated under Chapter 7 of the Bankruptcy Code. 

Counterparties to executory contracts with the debtor are entitled to the cure of all defaults under the contract if the debtor seeks to assume the contract and may also be entitled to adequate assurance of future performance where appropriate.  Landlords are entitled to payment of rent accruing post-petition until their lease is assumed or rejected, and upon assumption, the debtor must pay any unpaid prepetition rent. 

Takeaway

Subchapter V can be a very effective tool for small businesses to reorganize.  By permitting only debtors to file reorganization plans and allowing business owners to retain their equity interest without paying all unsecured creditors in full, Subchapter V allows business owners to maintain control of the reorganization.  By eliminating creditors’ committees, the requirement to file a disclosure statement and shortening plan timelines, expenses can be significantly reduced in comparison to typical large Chapter 11 cases.  Like all bankruptcy cases, a filing under Subchapter V will halt all collection actions, centralize the claims resolution process and give businesses breathing room to formulate a reorganization plan and eliminate debt. 

In short, Subchapter V offers a viable alternative for small businesses to stay in business, while streamlining its capital structure and operations.  The main downside to Subchapter V is the small amount of debt permitted to reorganize.  While the CARES act significantly increased the debt limits to qualify (from $2,725,675 to $7,500,000), it still only allows a modest amount of debt and that increase in debt limits expires in less than a year.  Also, the quick timeline to formulate and file a plan means many debtors will need to enter bankruptcy with a scheme to reorganize already formulated.

Still, small businesses are a major driver of jobs and wealth for millions of Americans.  Subchapter V will allow more of these small businesses to survive economic turmoil and emerge as leaner and stronger businesses.   

 

For any questions about this article or about a bankruptcy matter you may have, please contact Andrew E. Weissman or call (312) 648-2300.

[DISCLAIMER – This information is solely for information purposes and does not constitute legal advice. Please contact SFBBG with all legal questions.]