We are experiencing an economic disruption unlike any in our lifetimes. With the wholesale interruption of many business segments, market volatility, and the current stay-at-home order, it is difficult to get a handle on the long-term impact of COVID-19 on our economy and the small businesses that are a fundamental part of that economy. To protect our nation’s small businesses, the Federal government is providing stimulus checks to every household, and is also offering several SBA loan programs as part of the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”).
While Indiana has placed a moratorium on residential foreclosures and evictions, and nearly all civil actions and sheriff’s sales are delayed, there is no current prohibition on business foreclosures and evictions. The temporary delay in legal proceedings moving forward may allow for some breathing room for companies, but when a business is prohibited from doing business with its customers, how will it pay its accrued rent and other expenses when we return to some semblance of normal? While the media has largely focused on the economic stimulus elements of the CARES Act, it also contains amendments to the Bankruptcy Code that expand the availability of small business Chapter 11 bankruptcy relief to more small businesses, in the event SBA loans and lender workouts do not provide the relief necessary to weather the storm.
Traditionally, Chapter 11 bankruptcies have been a difficult last resort for small businesses; – having been costly and taking years to resolve. Unless secured creditors are wiling to cooperate and compromise with small business debtors, the result of Chapter 11 is often an unsuccessful dismissal or a liquidation. In a standard Chapter 11, at least one “impaired” group of creditors must approve a plan of reorganization, and under the “absolute priority rule,” it can be difficult for owners to satisfy conditions necessary to retain their ownership interests in connection with reorganization.
The Small Business Reorganization Act of 2019 (the “SRBA”) became law in August 2019 and went into effect on February 19, 2020. The SBRA streamlines the Chapter 11 process for eligible individuals and small businesses through a new Subchapter V of Chapter 11. Few Subchapter V cases have been filed to date, but the hope is that SRBA will make Chapter 11 a viable option for eligible small businesses. Under the CARES Act, the debt ceilings for SRBA debtor eligibility have been temporarily increased, for one year, from $2,725,625 to $7,500,000, expanding the availability of Subchapter V to small business debtors that are considerably leveraged, including companies that have financed a fleet of vehicles, significant equipment and inventory, or commercial real estate. Under the SRBA, at least fifty percent (50%) of the debt must be related to the operation of a business. Contingent, non-liquidated claims, as well as intracompany and other “insider” debt are excluded from the debt ceiling calculation. Debtors comprised solely of a single real estate asset (i.e., a shopping center or apartment complex) are not eligible for Subchapter V under the SRBA.
Although a Subchapter V debtor maintains “debtor-in-possession” status unless revoked, a case trustee is appointed in each case, and that trustee plays a role much like a Chapter 13 trustee: the trustee collects and distributes plan payments, reviews the Debtor’s finances, participates in significant hearings, and is to play a key oversight rule in reviewing whether a plan should be confirmed.
Subchapter V seeks to streamline and reduce the costs of a Chapter 11 case. Absent unusual circumstances, there is no creditor’s committee. Quarterly fees are not owed to the United States Trustee, although the case trustee will be paid compensation after confirmation. Unlike other Chapter 11 cases, other administrative expenses (such as attorney fees) need not be paid in full upon confirmation and can instead be paid over the life of the plan of reorganization.
While extensions of time are allowed under some circumstances, Subchapter V anticipates the prompt filing of a plan, within ninety (90) days following the order for Chapter 11 relief. The mostly duplicative disclosure statement, which resembles a securities offering, is eliminated, although a plan must still contain financial projections and a liquidation analysis. Plan requirements are a hybrid of Chapter 13 and Chapter 11 principles. A small business debtor must commit all “disposable income” to plan payments (or property equivalent to disposable income) for three (3) to five (5) years, and the plan must be “fair and equitable” to each class of creditors. A creditor must still receive no less value than it would have received in a Chapter 7 liquidation. The “absolute priority rule” applicable in other Chapter 11 cases, which generally requires unsecured creditors to be paid in full before shareholders or members can retain their pre-bankruptcy interests, is not applicable to small business debtors and is a vital aspect of Subchapter V.
Unlike other Chapter 11 cases, a Subchapter V small business plan does not require the approval of an impaired class of creditors. The ability to receive Bankruptcy Court approval without creditor consent, as in a Chapter 13 case, is of critical benefit to small business debtors, as it will increase the probability of plan confirmation. Even if an impaired class of creditors does not consent to the “cram down” of secured claims to the value of the secured collateral, a plan may be approved. The timing of a small business debtor’s discharge will almost always occur shortly after the successful completion of the plan. Because the absolute priority rule is inapplicable in Subchapter V, it is more likely that small business owners will retain company ownership and control following plan confirmation.
A few other SBRA Act changes are worthy of mention. An individual debtor who qualifies as a small business debtor will be able to modify a residential mortgage for a principal residence, but only if the proceeds of the mortgage were primarily used for small business purposes. And while most provisions of the SRBA benefit debtors, some new restrictions were placed upon preference recovery proceedings, a type of lawsuit often used in Chapter 11 cases to pursue certain pre-bankruptcy creditor payments for the benefit of the bankruptcy estate, a change presumably intended to curtail litigation of questionable value.
Small businesses should not only continue to assess the availability and potential benefit of SBA loans and other stimulus programs available to them, as well as consensual workouts with key creditors, but should also review other available contingencies provided through the CARES Act, including the expanded opportunities for bankruptcy reorganization. Unfortunately, not every small business will qualify for the new loan programs, and borrowers may continue to struggle to recover from significant cash flow interruptions. No small business owner wants to consider a Chapter 11 reorganization, but considering current economic uncertainties, it may be a viable alternative available to prevent closure and liquidation.
Hodges and Davis, P.C. – April 2020
This Article is a brief summary of recent changes to Chapter 11 of the Bankruptcy Code, including the temporary amendments to the SRBA included in the CARES Act. The information provided in this article does not constitute legal advice nor does it establish an attorney/client relationship. Should you have any questions regarding this article, please contact Hodges and Davis attorney Shawn Cox.