Recession may force small business to seek bankruptcy protection. The slowdown of the economy projected for this year or the next could bring many small businesses in the U.S. to the brink of closing its doors. Many companies that have been struggling are in danger of undergoing liquidation.
Now is the time to explore all possibilities and to review what resources are being offered by the Government and its institutions to cross the chasm.
One of these resources is the new Subchapter V of the Bankruptcy Code. It went into effect early this year.
It was not meant to be in response to this specific crisis, the coronavirus pandemic, but it is now a timely tool for businesses and individuals seeking protection and help under the current conditions.
The Small Business Reorganization Act of 2019 (SBRA) was signed into law in August 2019 and it is effective since February 19, 2020.
The SBRA is known as Subchapter V, referring to new Subchapter V of Chapter 11 of the Bankruptcy Code. It is meant to be a streamlined alternative to Chapter 11 for small business filing for bankruptcy protection and reorganization, that would permit them to act more quickly and with less preparation in these times when often speed is of the essence.
Subchapter V may allow small businesses to stop making payments towards their outstanding liabilities, and to take a respite. This pause will permit them to negotiate with creditors of all types, with lenders, landlords, suppliers, and others. The debtor will propose a payment plan under the examination and approval of the authorities, and this will lead to resume normal operations once the situation is under control.
There seems to be an extended opinion that a small business facing serious difficulties should seek Subchapter V protection in earnest, to avoid the unravelling of the consequences.
Paycheck Protection Program (PPP)
I only want to mention in passing, but now that we are talking about help programs promulgated by the Federal Government or other institutions, that there is a clash between the Subchapter V and the CARES Act.
The CARES Act introduced the Paycheck Protection Program (PPP) which is a loan for small business directed to maintain workers in their jobs. The Small Business Administration (SBA) limits eligibility to this program for entities already in bankruptcy. Businesses filing for bankruptcy are ineligible for the Paycheck Protection Program (PPP).
This is important because Subchapter V filings from PPP borrowers are expected to surge at some point if business conditions do not improve as needed by these enterprises. It is simply a situation where crossing all the t’s is extremely difficult and somehow business owners and employees need to choose.
Background: The Bankruptcy Code
To bring context to the promulgation of the new Subchapter V it is convenient to understand that in the Bankruptcy Code there are three main types: Chapter 7, Chapter 13, and Chapter 11. There are other types but only applicable to special situations that we will not review here. The Subchapter V has been added to the section of the Code covering Chapter 11. It is a section of Chapter 11.
Let us review briefly what is the purpose of each of these types.
Chapter 7
This is the type of bankruptcy that comes to mind first when the subject is brought up with a client. In it the debtor pays all of his debts to the extent of his resources and then it is done.
This is the main characteristic of Chapter 7: it is a liquidation of assets to pay creditors.
The process is undertaken in an orderly way, beginning with a classification of the assets in exempt and nonexempt. Exempt assets are excluded and are not sold by the Trustee to pay the creditors. The exempt assets which escape being sold are not many. In many states the types of personal property that are exempt are a car, household goods, clothing, ewelry, wedding rings, books, food, appliances, tools of your trade, and tax-exempt retirement accounts. But only up to certain amount.
Florida has one of the most generous homestead exemptions in the entire country. Even if you have equity in your home the homestead exemption can allow you to keep the house instead of having it liquidated to use the equity to pay c reditors. Busines entities file a Chapter 7 business bankruptcy.
This is different from a Chapter 7 personal bankruptcy. Filing a business bankruptcy lets the owners turn their business over to the trustee for an orderly liquidation.
But Chapter 7 might not be convenient for business debtors who want to remain in business, as in the case of corporations, partnerships, and sole proprietorships. They may prefer to avoid liquidation.
For these debtors filing a Chapter 11 and seeking reorganization should be a better option.
Sole proprietorships may also be eligible for relief under chapter 13 of the Bankruptcy Code.
Chapter 13
If somebody’s income is too high, she will not be approved for a Chapter 7 and should seek instead to file for a Chapter 13. This limitation to Chapter 7 eligibility is called the “means test”. Naturally, it does not imply that a person who fails the means test will be automatically approved under Chapter 13. She still needs to apply.
Only consumers, not businesses, can file for Chapter 13. Sole Proprietors are not entities independent of their owners. They are individuals “doing business as”. This is why Sole Proprietors can file under Chapter 13.
Chapter 13 involves a plan to pay creditors over time. Individual debtors propose a plan to pay their obligations in installments covering three to five years. The amount of debt to be paid is negotiated and can be a partial figure after obtaining an adjustment of debts. It follows that an individual filing a Chapter 13 must have sources of income.
If the debtor’s current monthly income is less than the applicable state median, the plan will be for three years unless the court approves a longer period “for cause”. These are inappropriate actions of the debtor, such as breach, misfeasance, fraud or any other.
If the debtor’s current monthly income is greater than the applicable state median, the plan generally must be for five years. During this time, the law forbids creditors from starting or continuing collection efforts.
Chapter 11
Chapter 11 is mainly for businesses but sometimes it is used by individuals. In the case of businesses this bankruptcy is referred to as a “reorganization” bankruptcy, and it applies to corporations, sole proprietorships, or partnerships.
The general idea is that the business, under supervision of appropriate entities, undergoes a process of re-focusing and becomes not only capable of paying its debts, but survives the bankruptcy to thrive later on clean of all the clutter that triggered the bankruptcy in the first place.
The idea is not to liquidate the assets of the debtor, as it is under a Chapter 7, or to propose a payment plan, as in Chapter 13, based on an existing stream of income. The idea is to safeguard and augment this stream of income, to rationalize the operations that would permit this income to exist. Its goal is, therefore, a little more ambitious than in the case of the other two Chapters that we are reviewing.
If the entity filing for bankruptcy is a corporation, naturally the assets under consideration exclude personal property of the stokholders. If the case involves a partnership, however, some of the personal assets may be involved and therefore, the partners may require themselves to request bankruptcy protection. For a sole proprietorship, that is an entity with an identity that is not separate from its owners, this may be the case as well.
Frequently, individuals filing Chapter 11 bankruptcy do so because they have exceeded the debt limits for a Chapter 13 bankruptcy. People with income and debt over the limits permitted for the latter type of bankruptcy, or seeking other benefits under the law, try to qualify for a Chapter 11.
There are many reasons why the bankruptcy petition of an individual or a business gets dismissed. In this place I only want to highlight the debtor’s responsibility and participation. For instance, willful failure to appear before the court or comply with orders of the court, are causes for dismissal, as it is the failure to receive credit counseling within 180 days before filing.
Improvements To Chapter 11
The principal motivation of the new Small Business Reorganization Act of 2019 (SBRA) is to provide a more compact and easier version of Chapter 11 reorganizations for small business corporate and individual debtors.
Existing Chapter 11 procedural requirements were a burden to small business filing for bankruptcy, to the point where many cases seeking debt relief with Chapter 11 finished instead in loss of ownership.
Filings under Chapter 11 usually took a long time to complete and were difficult to manage. Exhausting procedural and reporting burdens, the many difficulties to manage and unify the disparity claims of the Creditor Committee, the high counsel and advisory costs, and the depletion of resources witnessed by the tactical fighting and innumerable quid pro quos under consideration are procedural aspects of Chapter 11 were hindering its usefulness for small businesses.
For these and other reasons, Chapter 11 had a low percentage of success and filers were often forced to convert their Chapter 11 petition to a Chapter 7 liquidation plan.
Before the Small Business Reorganization Act of 2019 (SBRA), or Subchapter V as it is known, that became affective in February of 2020, there are several antecedents in the effort to help small business.
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) underlined the need for a simpler Chapter 11 process for small businesses, for example, by simplifying the plan solicitation and confirmation process. It was felt however, that BAPCPA had fallen short of its goals and that in some instances, as with the reporting requirements and other procedural issues, the burden had rather increased for small businesses.
It is finally with SBRA that a better solution has been implemented. SBRA simplifies the bankruptcy process for small businesses, lowers costs and facilitates the plan confirmation. Because of its flexibility and scope, it may provide the break that a small business in trouble needs to regain control of the situation.
Amount Of Debt And Types Of Debts
The SBRA statute is directed to help the small business debtor. But the main definitory characteristics of this entity have been a matter of some controversy. In particular, the limitation concerning type of debts and debt amount is important. The filing entity must have aggregate non-contingent liquidated secured and unsecured debts of $2,725,625.00 or less, excluding debt owed to affiliates or insiders.
Without attempting to produce here a single definition of “non-contingent” since this is a matter of law, let us say for reference only that these are debts that are fully established and do not depend on future events to be sure liabilities of the debtor. The term “liquidated” describes something similar. These are debts where the dollar amount if clear and fixed with precision or has been agreed upon between the parties or by operation of the law.
“Secure” and “unsecured” refer to existing collateral or not, as in the case of a mortgage and a credit card, respectively, where the latter lacks any interest in a security item.
Therefore, only a business debtor with non-contingent, secured and unsecured debt less than $2,725,625 may elect Subchapter V treatment. But many small businesses that could benefit from the SBRA exceed this modest threshold.
Not only that. Some people think that lenders could extend additional credit to borrowers on the upper end of the permissible range. In this way the lender would be able to disqualify the borrower from a Subchapter V election.
On the other hand, it has been suggested that since the limit applies to “non-contingent” debt, some debtors could increase the limit by reclassifying fixed debts as contingent or disputed. In this form they would qualify for Subchapter V.
Against this loud background, on March 27, 2020, Congress increased the cap to $7,500,000 for the next year as part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act., following advocacy efforts from the National Bankruptcy Conference and other stakeholders in the restructuring industry.
Creditor Committee
One of the important differences between a Chapter 11 and a Subchapter V is that a Subchapter V has no Creditor Committee. In a Chapter 11, a Creditor Committee can be a serious obstruction to having a plan approved. In fact, in a Chapter 11, a single creditor can stop such a plan from being approved.
In a Subchapter V by contrast, there is no requisite approval of the plan by creditors.
The vote to accept debtor’s repayment plan is no longer needed. This is sometimes called a “one step confirmation” meaning that the confirmation does not require the creditors approval of the plan.
In a Subchapter V, if the creditors cannot agree on the petitioner’s proposed plan, an application can be made to the Bankruptcy Court Judge to order the plan approved. The success of such a proposed plan need only be more attractive to the unsecured creditors than would a conversion to a Chapter 7 liquidation plan, which often is not an exceedingly difficult threshold to meet. Creditors’ committees are formed only for cause in Subchapter V cases, such as fraud or gross mismanagement.
Absolute Priority Rule
The Absolute Priority Rule has also been eliminated.
The Absolute Priority Rule establishes that for a debtor to have an ownership interest in the assets under liquidation, all creditors should be paid.
The rule refers to the order of payment of creditors. Secured claims always take precedence over unsecured claims, as credit cards. And senior creditors are paid in full before junior creditors.
The elimination of this rule means, among other things, that small business owners could not need to fully repay their unsecured creditors and could keep possession of assets that otherwise would be liquidated.
One case where this ruling is favorable to small business owners is when they took out a mortgage of their residence to finance their business. Under Subchapter V a second mortgage can be treated as an unsecured debt. As with other unsecured debts, this can be potentially discharged.
Adverse Personal Consequences
Subchapter V also cushions small business owners from certain adverse personal consequences that might otherwise disincentivize a Chapter 11 filing.
For example, if the debtor’s principal used his or her primary residence as security for a loan to fund the small business, the debtor’s plan may modify the loan.
Additionally, Subchapter V eliminates the so-called “new value rule”, which normally requires equity holders to provide “new value” if they want to retain their equity interest in the business.
As we mentioned before, the Subchapter V eliminates the Absolute Priority Rule that required that for a debtor to retain an ownership interest in the assets susceptible of being liquidated, all creditors should be paid in full.
The Courts have ruled, however, that a debtor can retain an interest in the assets if it contributes “new value”, new capital, to fund the plan. Creditors can object, in Chapter 11, that the “new value” is inadequate, to force the liquidation of more assets. Under Subchapter V debtors could retain ownership of the assets without contributions of “new value”.
Trustees Alongside Debtor In Possession
Normally, a Chapter 11 trustee is appointed only for cause, such as fraud or gross mismanagement, and seizes control of the debtor’s operations. Under Subchapter V, a trustee is automatically appointed, but the debtor retains control of its assets and operations. The petitioner is then a “Debtor in Possession”.
Although Subchapter V trustees have authority to investigate the debtor’s financial affairs, their primary function is to facilitate a consensual plan among the debtor and its creditors, almost like a mediator would facilitate a settlement in litigation.
The involvement of an impartial third-party may increase the likelihood of a fair and equitable resolution among the debtor and its creditors, and may be particularly useful for a small business whose creditors are unwilling to make reasonable concessions in light of the impending financial crisis.
Single Asset Real Property
One important exclusion is the case of an entity that obtains all its income from the operation of a “single asset real estate” (SARE) property. This entity is excluded from filing under Subchapter V. It does not fall under the definition of a “small business debtor”.
“Single asset real estate” is defined in the Bankruptcy Code as a single property or project, other than residential real property with fewer than four units, that generates substantially all of the debtor’s gross income (§ 101(51B), Bankruptcy Code).
If these three conditions are met, this is if the real property constitutes a single property or project, if the debtor’s only business is operating the property and if the property generates substantially all of the debtor’s income, then office buildings, industrial and warehouse buildings or apartment complexes that comply with them are excluded from filing under Subchapter V.
These three conditions are frequently litigated.
SAREs are excluded in general terms because they have specific treatments going back to the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) and their conditions call for these special treatments. These are commercial real estate projects looking for debt relief under bankruptcy.
Fees
Another benefit from the disappearance of the Creditors Committee are the reduced professional fees. There is no need under this new code to deliver costly disclosure statements required by Chapter 11.
Furthermore, other than the initial filing fee, fees are essentially eliminated, making the process much less expensive to the petitioner.
Length Of Payment Plan
Much like a Chapter 13 case for individuals with regular monthly income, Subchapter V allows a debtor to spread its debt over 3 to 5 years, during which time the debtor must devote its projected disposable income to paying creditors.
In many cases, this model benefits both debtors (by allowing them to spread payments over time) and creditors (by allowing them a meaningful recovery from debtors who may not have much money on hand but have a realistic expectation of income over time).
Administrative Expenses
In a traditional Chapter 11 case, administrative expenses must be paid at plan confirmation; under Subchapter V, they may be paid over the life of the plan.
Debts, on the other hand, are not discharged until the debtor completes all of its plan payments.
Required Documentation
To file under a Subchapter V, the entity will require the business’ most recent balance sheet, profit and loss statement, cash flow statement, and federal income tax return.
Other documents that might be needed are Articles of Incorporation, State documentation and state income taxes, bank statements, contracts with providers or lenders and other documents associated with the operation of the business.
Pace Of The Bankruptcy Filing
The pace is swift, take this in consideration. The plan of reorganization must be submitted for approval by the debtors within 90 days after entering bankruptcy. Therefore, much of the work should be completed by the petitioner and their attorney during what could be thought of as a pre-submission period.
However, the Bankruptcy Court may extend this 90-day deadline “if the need for the extension is attributable to circumstances for which the debtor should not justly be held accountable.”
This is the case in the present COVID-19 environment. We think that courts are likely to grant extensions more easily.
What This Office Offers
This office handles all types of bankruptcy petitions, advises clients, and represents them in front of the Court. This office offers also various debt relief strategies applicable to different situations.
For instance, we pursue loan modifications for mortgage debtors or try to reach settlement agreements with creditors that would prefer a lump sum now than a protracted installment plan. On other occasions we need to get ourselves involved in a litigation against claims that a breach of contract has occurred.
This office will represent a small business filing for Subchapter V bankruptcy protection under the Small Business Reorganization Act of 2019 (SBRA).