January 29, 2020
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The Small Business Reorganization Act of 2019 (the “Act”) was executed on August 23, 2019 and becomes effective in February 2020. With the Act, Congress amended the current Bankruptcy Code and Title 28 of the U.S. Code to provide new rules and procedures for “small business debtors” that need to utilize the Chapter 11 bankruptcy process to pay off creditors and emerge from financial distress.
Prior to the Act, Chapter 11 bankruptcy was primarily utilized by large businesses and public companies to stave off creditors from exercising legal remedies to recover unpaid debts; however, the Act makes Chapter 11 bankruptcy a realistic option for small business debtors to do the same.
Below, we highlight key components of the Act that make the Chapter 11 process less arduous on small business debtors, enabling those debtors to restructure debt and improve current cash flow and their financial condition. A small business debtor may want to resort to filing for Chapter 11 bankruptcy if it has exhausted other options and does not want to resort to ceasing operations or liquidating its assets to satisfy debts.
What is “Chapter 11 Bankruptcy” & “Restructuring”?
Bankruptcy is a legal proceeding that individuals and businesses resort to in order to satisfy debts that individual or business income are unable to pay and offers an individual or business the opportunity for a fresh start. Creditors, on the other hand, are able to submit a claim for the outstanding amount of debt owed by a bankrupt debtor and are provided a chance to recover some (or most, depending on that creditor’s priority) of the debt owed.
Bankruptcy filings in the U.S. typically fall under three chapters of the bankruptcy code:
- Chapter 7 (individual or business asset liquidation),
- Chapter 11 (plan of reorganization of debts), or
- Chapter 13 (individual plan of reorganization of debts under specified limits) [i].
Chapter 11 allows a business debtor that is struggling to service its required debt payments to restructure the repayment of that debt by creating a plan and continue to operate its business while the plan is being executed. A Chapter 11 debtor can use a plan of reorganization to reduce its current payment obligations by aggregating those obligations into one periodic payment that is spread over an extended period of time. As a result, a debtor may regain profitability, balance income and expenses and continue to operate as opposed to defaulting on certain payment obligations, subjecting its assets to seizure or foreclosure, or completely discontinuing operations.
Additionally, Chapter 11 debtors benefit from the “automatic stay.” The automatic stay legally requires creditors to stop almost all proceedings and credit collection activities by against the Chapter 11 debtor. This provides the debtor with a period of temporary relief so that it may address its business issues and reorganize its debts without pressure from creditors. Debtors usually use this time to develop payment agreements with creditors and then presents a “plan of reorganization” to the bankruptcy court. If this plan is approved by the court and the creditors that own the required amount of the outstanding debt (as approval is tied to a dollar amount of debt outstanding compared to a certain number of creditors) then the debtor can retain control of its assets and continue business operations. Note, however, that a Chapter 11 debtor will be subject to heightened reporting requirements to the bankruptcy court and closely monitored by a bankruptcy trustee or committee of creditors.
Subchapter V Improves the Feasibility of Chapter 11 for Small Business Debtors
Those that criticize the Chapter 11 bankruptcy process often state that Chapter 11 was designed for larger corporations with complex operations and capital structures instead of small businesses that have a single owner or are managed by a few family members. As a result, distressed small businesses resort to Chapter 7 bankruptcy due to inability to pay high administrative costs or difficulty with completing the required elaborate disclosures. Further, those small businesses that complete the initial requirements are faced with excessive influence from secured creditors. Subchapter V, which was created by the Act, provides a solution to these issues and removes some of the conditions that make Chapter 11 too arduous for small business debtors.
Who Qualifies as a “Small Business Debtor”?
Under Section 101(51D) of Bankruptcy Code, a Small Business Debtor is a business entity (or individual engaged in business) whose aggregate non-contingent debts (excluding debts to affiliates or insiders) do not exceed $2,725,625, and who elects to be treated as a small business debtor pursuant to the requirements included in Subchapter V. The Act increased the debt limit from $2 million, which enables more businesses to qualify as Small Business Debtors for Chapter 11.
Changes Under the Act
- Establish a trustee
The Act includes a requirement that appoints a standing trustee in all Subchapter V proceedings. The trustee oversees the bankruptcy throughout the term of the plan, which can be a short as three years, but no longer than five years. A trustee will analyze the debtor’s property and determine the value, work with the debtor and its creditors to develop a plan of reorganization for the debtor, and supervise the property and funds distributed under the plan. The trustee is further motivated to get parties to agree to a plan because it is compensated based on a percentage of the distributions made by the debtor to the creditors, rather than a portion of the proceeds of the debtor’s sale of its assets.
- Moves more swiftly
A Subchapter V case is anticipated to move much faster as a result of the Act. A small business debtor must file a reorganization plan within 90 days of commencement (although this may be extended under limited circumstances). A small business debtor is also not required to file a disclosure statement, and as a result, does not have to pay the costs of producing the document or spend the time. An initial status conference is required in every case within 60 days of commencement, where the trustee will determine if a small business debtor has a realistic chance of completing a plan of reorganizations. If a trustee determines that a small business debtor has the capacity to complete a plan of reorganization, it will work with the debtor and creditors to have a plan confirmed.
- Simplified ballot filing
Prior to the Act, a creditor had to vote for or against a plan and may not timely file its ballot in support or objection of the plan. Now, however, the Act treats a creditor’s untimely filing of a ballot as automatic acceptance of the plan. This can reduce some of the undue pressure that a creditor can provide to a small business debtor to agree to a plan that satisfies the creditor. If a trustee or a holder of an unsecured claim objects to the plan, however, the bankruptcy court cannot approve the plan unless it provides that all of the small business debtor’s projected disposable income received during the plan is paid to unsecured debtors during the plan. A bankruptcy court can also, however, confirm a debtor’s plan without the support of any class of claims, so long as the plan does not discriminate unfairly and is fair and equitable with respect to each class of claims or interests.
- New take on personal residences used as collateral
In its early stages, small businesses that are seeking access to capital to execute growth strategies or inject working capital into the business often pledge personal residences as security for loans. Under the Act, mortgages secured by a residence are modified if the mortgage was taken out for the purpose of financing the debtor’s business. Such modifications may include splitting the mortgage into secured and unsecured debt based on how much equity the debtor has to support the mortgage, with the unsecured portion being treated like all of the other unsecured debt in the restructuring plan. This may allow a small business debtor to pay back a portion of their mortgage with negotiated flexible deadlines and lower interest rates. A small business that is struggling financially and considering shutting down its business should strongly consider taking advantage of the streamlined and less-costly Subchapter V bankruptcy process.
** Special thanks to PIDC’s Tarik Brooks and Efraim Burle for contributing this article.
*** DISCLAIMER: This article has been prepared and published for informational purposes only and is not offered, nor should it be construed, as legal or accounting advice on any specific facts or circumstances. The contents of this article are intended for general informational purposes only and you are urged to consult an attorney, or other professional, concerning any particular question that you may have.
[i] Note that the more common uses of each Chapter are highlighted. Special circumstances may cause a debtor to use a different chapter of the bankruptcy code than those summarized.