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The Small Business Reorganization Act of 2019 Gives Financially Distressed Small Businesses a New Lifeline

Small and mid-sized companies often find it difficult to use Chapter 11 to successfully reorganize and Chapter 11 forces distressed firms to incur significant professional fees, and the U.S. Bankruptcy Code imposes numerous administrative burdens on debtors. If an official committee is appointed in a Chapter 11 case, the debtor must pay the fees and expenses of the committee’s professionals as well. As such, a full-fledged Chapter 11 case may not be a viable restructuring alternative for many distressed companies. Even if it is a feasible restructuring tool for a particular debtor, the Bankruptcy Code’s “absolute priority rule” often requires existing equity owners either to relinquish ownership of the business, or to invest new money to retain their ownership stake.

The Bankruptcy Code currently provides that a “small business debtor” may proceed in Chapter 11 under slightly-modified rules. (For a debtor to be a “small business debtor,” (a) it may not have more than $2,725,625 in non-contingent, liquidated, secured, and unsecured debts (excluding debts owed to affiliates; or insiders), and (b) no official unsecured creditors’ committee must have been appointed, or if one already has, the bankruptcy court must determine that the committee is not sufficiently active and representative.)

However, these existing rules do not materially reduce the costs and burdens of Chapter 11, nor do they increase the likelihood that existing equity owners can retain ownership of the business under a Chapter 11 reorganization plan. Additionally, there are rules specific to small business cases that may make it more difficult for a small business debtor to successfully reorganize under existing law. For example, any Chapter 11 plan must be filed within 300 days of the bankruptcy filing. This deadline may prove impossible to achieve if the case is complex or if there are significant disputes. Moreover, small business debtors are subject to heightened oversight and scrutiny from the Office of the United States Trustee, and small business debtors that file multiple bankruptcy cases might not benefit from the bankruptcy automatic stay.

Because of Chapter 11’s shortcomings, many small and mid-sized companies choose alternative restructuring processes to bankruptcy, including out-of-court workouts or sales, assignments for the benefit of creditors, receiverships and “friendly” foreclosures. Some particularly unfortunate companies are forced to liquidate, resulting in job losses and destruction of enterprise value.

Congress has decided to address these problems by enacting the Small Business Reorganization Act of 2019 (the “SBRA”), which will become effective in February 2020. The SBRA is designed to foster successful restructurings of small businesses, and thereby save jobs and preserve enterprise value. Among other things, the SBRA adds a new “Subchapter V” to Chapter 11 of the Bankruptcy Code, which contain some new tools to increase a small business debtor’s chances for a successful reorganization. Once the SBRA takes effect next February, a small business debtor that files Chapter 11 may either (A) proceed under the new Subchapter V of the SBRA, or (B) proceed under the existing Chapter 11 small business debtor rules.

Subchapter V of Chapter 11: Key Features

A. Existing Equity Owners Have a Better Chance to Retain Their Ownership of the Debtor

A small business debtor proceeding under Subchapter V may have its proposed Chapter 11 plan confirmed over the rejection of one or more classes of creditors, so long as the plan provides that all of the debtor’s projected “disposable income” during the following 3 to 5-year period will be applied to make payments to creditors. Alternatively, the debtor may propose a Chapter 11 plan that provides for the distribution of some or all of its property to creditors, as long as the property to be distributed under the Chapter 11 plan is not less than the projected “disposable income” of the debtor.

Importantly, the term “disposable income” means the income that the debtor receives that is not reasonably necessary to be expended for the payment of expenditures necessary for the continuation, preservation or operation of the debtor’s business. This means that the debtor can fund a Chapter 11 plan under Subchapter V with only its projected profits, making it more likely that a debtor can “afford” its Chapter 11 plan.

As long as the debtor’s Chapter 11 plan under Subchapter V does not “discriminate unfairly,” is “fair and equitable,” and the debtor successfully performs under its Chapter 11 plan, equity owners may retain their ownership of the debtor. This is a momentous departure from the traditional “absolute priority rule” in Chapter 11 cases, which usually requires existing equity owners to relinquish their ownership interests, or to invest new money to retain their ownership stake.

B. Only the Debtor May File a Chapter 11 Plan in a Subchapter V Case, But the Timeline to Do So Is Shortened

Under the SBRA, only the debtor in a Subchapter V case may file a Chapter 11 plan. The initial exclusivity period under the existing small business debtor rules is 180 days, which can be extended or shortened for cause. Once the exclusivity period expires under normal Chapter 11 procedure, any party may file a plan. Under Subchapter V, on the other hand, no party other than the debtor will be permitted to file a plan.

The SBRA further provides, however, that in a Subchapter V case, the debtor must file a plan within 90 days after the order for relief in the case, unless the bankruptcy court extends that period after determining that the “need for the extension is attributable to circumstances for which the debtor should not justly be held accountable.”

Under the existing small business debtor rules, a plan must be filed within 300 days of the order for relief. Thus, under Subchapter V, a debtor will have significantly less time to file a Chapter 11 plan than it would have under the existing small business debtor rules.

C. Presumption Against Requiring Disclosure Statements, and Against the Appointment of Official Unsecured Creditors’ Committee

In Chapter 11 cases, a proposed plan must be accompanied by a disclosure statement, which is a lengthy document that describes the debtor’s business operations, discusses the terms of the proposed plan, and provides other information. Creating a disclosure statement typically requires the expenditure of significant professional fees, and the disclosure statement approval process delays a debtor’s exit from Chapter 11. Under the existing small business debtor rules, disclosure statements are required unless the court determines otherwise. Under Subchapter V, however, the presumption is reversed, meaning that disclosure statements will not be required unless the bankruptcy court orders that a disclosure statement be filed. This reversal of the disclosure statement presumption can save Subchapter V debtors significant time and money.

Additionally, under the SBRA, there will be a presumption that an official unsecured creditors’ committee will not be appointed under either the existing Chapter 11 small business debtor rules or under new Subchapter V. Under existing law, there is a presumption in small business debtor cases that official creditors’ committees will be appointed. Because the debtor must pay the court-approved fees of the professionals of official committees, all small business debtors (regardless of which of the two small business Chapter 11 tracks it chooses) will benefit from this change in the law.

D. Automatic Appointment of a Trustee in Subchapter V Cases

The SBRA requires the appointment of a trustee in every Subchapter V case. Although management normally will remain in place in Subchapter V cases unless removed by the bankruptcy court (just as it does in other Chapter 11 cases), the Subchapter V trustee will have numerous oversight responsibilities. For example, a Subchapter V trustee will be responsible for reviewing the debtor’s financial condition and business operations, reporting any fraud or misconduct to the bankruptcy court, and supervising the debtor to ensure that distributions are made in accordance with the debtor’s Chapter 11 plan. The trustee’s service will ordinarily terminate once a Chapter 11 plan under Subchapter V is substantially consummated. The debtor will be responsible for paying the fees of the trustee.

E. Possibility for Removal of Management After Consummation of a Chapter 11 Plan

Under the SBRA, if the debtor is unable to perform its obligations under a confirmed Chapter 11 plan under Subchapter V, the bankruptcy court may remove the debtor’s management and appoint a trustee. This is a departure from normal Chapter 11 practice, where bankruptcy courts generally do not retain jurisdiction to remove a debtor’s management after a Chapter 11 plan is consummated.

Benefits and Drawbacks to Electing Subchapter V Over the Existing Rules

When the SBRA becomes effective next year, small business debtors will need to choose whether to proceed under Subchapter V or under the existing small business debtor rules. There are several tradeoffs that a debtor will need to consider in determining whether to proceed under the existing small business debtor rules, or under new Subchapter V.

Benefits to choosing Subchapter V over the existing small business debtor rules include:

  • Subchapter V provides a greater opportunity for existing equity owners to keep their ownership interests, without the need for those existing equity owners to invest new money;
  • under Subchapter V, only the debtor may propose a Chapter 11 plan;
  • under Subchapter V, there will be no requirement that an impaired class of creditors accept the Chapter 11 plan;
  • in a Subchapter V plan, the debtor will not be required to pay post-petition administrative expenses in full and in cash on the effective date of the plan (instead, these post-petition administrative expenses may be paid over a period of time through the plan);
  • it will be easier to modify a Chapter 11 plan under Subchapter V after it is confirmed; and
  • a debtor in a Subchapter V case may retain professionals that hold claims against the debtor in an amount less than $10,000, which is a departure from the normal rules that require any professional to waive all of its claims against the debtor before it can be retained in the bankruptcy case. This provides more flexibility to debtors to choose the professionals that will represent them in bankruptcy.

Drawbacks to choosing Subchapter V include:

  • under Subchapter V, a trustee will automatically be appointed, which will add marginal expenses and administrative burdens on debtors;
  • there is possibility that the debtor’s management will be removed even after a Chapter 11 plan under Subchapter V is confirmed; and
  • under Subchapter V, the debtor initially has only a 90-day period to file a Chapter 11 plan, though the bankruptcy court may extend that period if the need for an extension is “attributable to circumstances for which the debtor should not justly be held accountable.” In comparison, under the existing small business debtor rules, the debtor has an initial 180-day period during which only it may propose a Chapter 11 plan.

Changes to the Bankruptcy Code’s Preference Statute

In addition to establishing Subchapter V, the SBRA modifies the current rules regarding actions to avoid “preferences,” which apply in all bankruptcy cases (not just small business debtor cases). Under the Bankruptcy Code, representatives of a debtor’s bankruptcy estate may commence lawsuits against creditors who had received transfers from that debtor within 90 days before its bankruptcy filing. In such an action, the debtor’s bankruptcy estate seeks to “avoid” and “recover” such transfers from creditors. Before the SBRA’s enactment, if the amount of the transfer at issue was less than $13,650, the estate representative is required to file the complaint in the federal judicial district in which the defendant resides (not in the district where the bankruptcy case is pending). The SBRA raises that dollar threshold for non-insider defendants to $25,000. This means that any action to avoid and recover transfers in an amount less than $25,000 must be filed in the district where the defendant resides. This is a boon to creditors who reside outside the federal judicial district in which the bankruptcy case is pending, because the estate representative would be required to commence the preference action in a different court.

In addition, the SBRA will now require a plaintiff in a preference case to conduct reasonable due diligence and to take into account the defendant’s “known or reasonably knowable affirmative defenses” to a preference action, before commencing the preference action in the first place. Notably, however, the defendant still retains the burden of proving its defenses to any preference action. This change in the law gives rise to several ambiguities. For example, how much due diligence is required it to be “reasonable”? To what extent is an affirmative defense “reasonably knowable” to a plaintiff? The answers to these questions will need to be determined by the courts.

Conclusion

By creating more expeditious Chapter 11 procedures, the SBRA will expand the class of small business debtors who may benefit from bankruptcy. When the SBRA becomes effective next February, debtors will need to choose whether to proceed under Subchapter V or under the existing Chapter 11 small business debtor rules. Because every debtor’s situation is different, however, prospective debtors should carefully consider the benefits and drawbacks of each option with their bankruptcy attorney before choosing which path to take.

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11.20.2019  |  PUBLICATION: Other Publications  |  TOPICS: Bankruptcy

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