CARES Act Expands Eligibility Under the Small Business Reorganization Act: What Distressed Small Businesses and Their Creditors Should Know

| Apr 22, 2020 | blog, COVID-19, Firm News |

The Coronavirus Aid, Relief and Economic Security (CARES) Act temporarily expands eligibility for “small businesses” to reorganize under chapter 11 over creditor objection under a new law that streamlines chapter 11 reorganizations

Subchapter V modifies or eliminates many traditional chapter 11 requirements, making it easier for small businesses to confirm plans of reorganization and owners to retain their equity and control.

The CARES Act temporarily (for the next year) allows companies with up to $7,500,000 (up from $2,725,625) in secured and unsecured non-contingent and liquidated debt to use Subchapter V to reorganize. This increase makes it possible for larger companies, with significant contingent and unliquidated debts that might otherwise reorganize under a traditional chapter 11, to qualify as a “small business debtor” and seek confirmation under the relaxed standards of Subchapter V.

Notwithstanding the debtor-friendly provisions of Subchapter V, several creditor protections – including the requirement that creditors receive at least as much as they would on liquidation (the “Best Interest Test”) and the ability of secured creditors to try to capture any post-confirmation increase in the value of their collateral through section 1111(b) of the Bankruptcy Code – remain and may help level the playing field.

The Small Business Reorganization Act of 2019, which created Subchapter V of chapter 11 of the Bankruptcy Code, became effective on February 19, 2020 (11 U.S.C. §§ 1181-1195 “Subchapter V”). Subchapter V was intended to mitigate perceived challenges faced by small business debtors, with no more than $2,725,625 in debt, in traditional chapter 11 cases. In response to the COVID-19 crisis, the CARES Act expands Subchapter V eligibility for a period of one year (or longer if extended by Congress) by increasing the cap to $7,500,000 in aggregate secured and unsecured non-contingent and liquidated debt. Widespread distress and decreased asset values along with the subchapter’s debtor-friendly rules likely will make Subchapter V an even more attractive option for larger than originally-contemplated businesses who seek to benefit from its short timeline (debtors must file plans of reorganization within 90 days), its reduced administrative expense (there is no disclosure statement to prepare and pay for, no creditors’ committee to fund, and no administrative fees to be paid to the United States Trustee), and its elimination of 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).

Eligibility for Subchapter V

To be eligible for Subchapter V, a debtor must meet the definition of a “small business debtor” and elect to be a Subchapter V debtor. With its CARES Act amendment, Bankruptcy Code section 101(51D) defines a small business debtor as a business:

engaged in commercial or business activities (including any affiliate … 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 … in an amount not more than $7,500,000 [previously $2,725,625]  (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.

The definition of a small business debtor, thus, excludes debts that are contingent (e.g., a claim based on a guarantee of someone else’s not-in-default debt) or unliquidated (e.g., a tort claim), likely because non-contingent, liquidated debts are a readily available measure of a debtor’s size. See In re Hustwaite, 136 B.R. 853, 855 (Bankr. D. Or. 1991) (concluding that Congress was concerned about “delay when it limited the kinds of debts to be included in determining eligibility….”). If not, for example, a “mom & pop” shop, with contingent liability for a slip and fall claim, might not be eligible for Subchapter V, as Congress intended.

Although there was always a risk that debtors might try to classify certain debts as contingent or unliquidated to squeeze into Subchapter V, the increase of the non-contingent, liquidated cap makes it possible for even larger companies, with significant contingent and unliquidated debts that might be able to reorganize under a traditional chapter 11, to qualify as a “small business debtor.” For example, a midsize business—with over 100 employees and $20 million in annual revenue—that is subject to $150 million in litigation claims, would qualify for Subchapter V as long as its noncontingent and unliquidated claims (e.g., trade and funded debt claims) total less than $7.5 million.

Whether larger debtors with significant self-designated contingent and unliquidated debt that try to shoehorn themselves into Subchapter V relief will succeed is unclear. Parties have had some success challenging a debtor’s small business designation in pre-Subchapter V cases. See, e.g., Coleman Enters., Inc. v. QAI, Inc. (In re Coleman Enters., Inc.), 275 B.R. 533, 539 (B.A.P. 8th Cir. 2002) (finding small business election void where noncontingent liquidated debts exceeded statutory ceiling); see also In re Buis, 337 B.R. 243, 250-52 (Bankr. N.D. Fla. 2006) (dismissing chapter 13 filing for bad faith because “timing of the bankruptcy filing was an ultimately futile attempt to keep the debtors eligible to file for relief under chapter 13….”). However, given its recent enactment, there is no case law yet testing a debtor’s designation in the Subchapter V/post-CARES Act context. The United States Trustee, which serves as the government watchdog in Bankruptcy Court, will likely continue to review actively the legitimacy of a debtor’s designation/non-designation and respond as it deems appropriate.1 And the Bankruptcy Rules give parties thirty days from the section 341(a) creditors’ meeting, or, if later, thirty days from the filing of an amended designation, to object to a Subchapter V designation. See Fed. R. Bankr. Proc. 1020(b).

Key Features of Subchapter V

Subchapter V modifies or eliminates many traditional chapter 11 requirements that made obtaining plan confirmation difficult and expensive for small businesses, including:

•Continued Ownership and Management. Non-consensual plan confirmation in Subchapter V differs radically from the “cramdown” rules of traditional chapter 11 cases. Under the absolute priority rule in non-Subchapter V cases, existing owners cannot retain equity in the debtor 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. Most often in small business cases, relinquishing equity is not a viable option for a small business, because the owners are the only managers willing or able to run the business. In addition, small business owners often do not have sufficient cash or ability to borrow to buy the debtor’s reorganized equity. Therefore, creditor consent often is a prerequisite to confirming a non-Subchapter V case, giving creditors substantial leverage over the small business owner.

In a Subchapter V case, as long as unsecured creditors are to be paid the debtor’s “disposable income” for a period of three years (or up to five years if extended by the court), equity holders will continue to own and manage their business, even where creditors all vote against the plan and object to confirmation. Disposable income includes income that is reasonably necessary to be expended “for the payment of expenditures necessary for the continuation, preservation, or operation of the business of the debtor.” 11 U.S.C. § 1191(d)(2).

•No Disclosure Statement Requirement. A chapter 11 disclosure statement is not required in Subchapter V, unless ordered by the court for cause. 11 U.S.C. § 1181(b). Elimination of the disclosure statement reduces costs significantly and expedites the plan confirmation process. The chapter 11 plan itself, however, must contain a brief history of the debtor’s business operations, a liquidation analysis, and projections with respect to the debtor’s ability to make plan payments. 11 U.S.C. § 1190(1).

•No Competing Chapter 11 Plans. Only a debtor may file a chapter 11 plan in a case under Subchapter V. 11 U.S.C. § 1189(a).

•Delayed Payment of Administrative Expense Claims. In contrast to a traditional chapter 11 case, where administrative expense claims have to be paid on a plan’s effective date or in the ordinary course of business, a small business debtor in Subchapter V may stretch out payment of administrative expense claims over the term of the chapter 11 plan. 11 U.S.C. § 1191(e).

•90 Days to File A Plan. Subchapter V debtors are required to file a plan not later than 90 days after entering bankruptcy, unless the need for the extension is caused by circumstances “for which the debtor should not justly be held accountable.” 11 U.S.C. § 1189(b).

•No Creditors’ Committee. Subchapter V provides that a committee of creditors will not be appointed unless ordered by the bankruptcy court for cause, thereby eliminating in most cases the costs of a creditors’ committee and its professionals paid for by the debtor. 11 U.S.C. § 1181(b).

•Appointment of a Specialized Trustee. Management of the debtor’s affairs remains with the debtor, although one or more Subchapter V trustees are appointed for all Subchapter V cases in each U.S. Trustee region to monitor the debtor’s affairs, evaluate the debtor’s assets, assess the debtor’s prospects for success, and make recommendations regarding confirmation of the debtor’s plan. See 11 U.S.C. § 1183(b). In a non-consensual plan confirmation, the trustee collects and distributes plan payments. See 11 U.S.C. § 1194(b). We expect that the Subchapter V trustee will be given substantial deference as courts consider confirmation of Subchapter V plans of reorganization.

•No U.S. Trustee Quarterly Fees. Subchapter V debtors are excused from the obligation imposed on other chapter 11 debtors to pay quarterly fees to the United States Trustee System Fund.2

Continuing Creditor Protections

Although Subchapter V provides small business debtors with substantial benefits, several important creditor protections in chapter 11 remain applicable. These include, without limitation:

•To confirm its plan of reorganization, the small business debtor must satisfy the so-called Best Interest Test by providing creditors at least as much as they would receive if the debtor were liquidated and not reorganized. 11 U.S.C. 1129(a)(7).

•Secured creditors retain the right to make an election under section 1111(b)(2) of the Bankruptcy Code to have the entire amount of their claims remain secured by their collateral, while receiving altered payment terms under the Plan. The effect of a section 1111(b)(2) election is to secure for the secured creditor any post-confirmation increase in the value of its collateral effectively upon its sale, at the expense of receiving payment on the unsecured deficiency part of its claim under the debtor’s confirmed plan of reorganization.

•Secured creditors retain their rights to have their collateral “adequately protected” against diminution in value or be granted relief from the Bankruptcy Code’s automatic stay to realize on their collateral. 11 U.S.C. 362(d).

•To assume executory contracts,3 small business debtors must still cure defaults and, where required, provide adequate assurance of future performance. 11 U.S.C. § 365(b).

•Claims for goods delivered within 20 days prior to the bankruptcy are still treated as administrative expenses claims under 11 U.S.C. § 503(b)(9).4

Each of these provisions, in appropriate circumstances, may be used by creditors to secure better treatment than that being offered by a Subchapter V debtor. Because Subchapter V is so new, however, there is not yet any case law guidance on how these creditor protections will be used and applied under the new law.

Conclusion

The debtor-friendly provisions of Subchapter V will expedite and decrease the costs of the chapter 11 process for small businesses. As companies continue to struggle with financial distress from COVID-19 and otherwise, we expect many businesses will utilize Subchapter V to reorganize. Some larger businesses will claim eligibility to fit within the post-CARES Act debt cap to take advantage of the revised “cramdown” rules for unsecured classes, the ability to spread out administrative expense payments, and the inability for other parties to file a competing chapter 11 plan. For debtors, Subchapter V presents an opportunity to save the business and continue ownership and management. For creditors, however, a fast-paced restructuring without certain creditor protections traditional to chapter 11 presents many potential pitfalls, although some basic creditor protections in chapter 11 remain unaltered by Subchapter V.

 

1.  See Adam D. Herring et al., New Laws, New Duties: The United States Trustee Program’s Implementation of the HAVEN Act and the Small Business Reorganization Act, ABI Journal (Vol. XXXVIII, No. 10, Oct. 2019), available at https://www.justice.gov/ust/file/abi_201910.pdf/download. We note that if a debtor qualifies as a “small business debtor” but does not elect Subchapter V treatment, the debtor still may reorganize under the small business debtor rules in effect since 2005. See id. at 2. We are aware of at least one case where, prior to the enactment of Subchapter V, the United States Trustee successfully moved to have a debtor deemed a small business debtor, where the debtor listed disputed unsecured debts exceeding $15 million, but did not designate itself as a small business debtor under other provisions of the Bankruptcy Code. Whether the same opportunity for the United States Trustee exists to try to compel a Subchapter V election is untested.

2.  See Pub. L. No. 116-54 § 4(b)(3) (amending 28 U.S.C. § 1930(a)(6) to exclude cases under subchapter V from cases responsible for payment of quarterly fees). For most pre-Subchapter V small business cases, fees to the U.S. Trustee could range from several hundred to several thousand dollars per quarter until the case is closed, dismissed or converted to a chapter 7 liquidation. See Chapter 11 Quarterly Fees, U.S. Tr. Program, https://www.justice.gov/ust/chapter-11-quarterly-fees (last visited Apr. 15, 2020).

3.  A contract is executory and can be assumed or rejected under the Bankruptcy Code if, as of the commencement of the bankruptcy case, material performance remains due from both the debtor and non-debtor parties. See Regen Capital I, Inc. v. Halperin (In re U. S. Wireless Data, Inc.), 547 F.3d 484, 488 n.1 (2d Cir. 2008) (an executory contract is “a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other.” (citation omitted)).

4.  Typically, having any portion of a prepetition claim treated as an administrative expense or a contract assumed requiring arrearages to be paid and future breach claims to be treated as administrative expense claims is welcome news for a creditor, and may encourage a creditor to continue to extend credit to a struggling company. If, however, Subchapter V debtors have the ability to defer payment of administrative expenses under 11 U.S.C. § 1191(e), as discussed above, a creditor may have less incentive to transact with a small business that is likely headed for chapter 11 if that credit extension need not be paid in full at the time of confirmation for the debtor to be able to confirm a plan.