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Chapter 11 Bankruptcy is Expensive; the Small Business Reorganization Act Provides a Realistic Opportunity for Small Businesses to Reorganize

July 2, 2020

Overview

Many commentators have long complained and many companies have experienced the reality that bankruptcy laws are too complex, costly, and onerous to successfully allow small businesses to survive by reorganizing in bankruptcy. Recent changes enacted as part of the Small Business Reorganization Act (SBRA)—and temporarily enhanced by the CARES Act—make bankruptcy reorganization much more affordable and viable for small businesses.

Prior to the enactment of the SBRA, bankruptcy options for small businesses were limited. A Chapter 7 bankruptcy brings a business and its ownership to an end, resulting in the liquidation of all of the entity’s property. A Chapter 11 bankruptcy, if successful, allows the business to continue operating. Management retains control of its business operations during the Chapter 11 process while also working to obtain court approval of its proposed “plan of reorganization.” The reality, however, is that the risk and costs of the Chapter 11 process (especially for a small business) are frequently prohibitive. While in a Chapter 11 bankruptcy, the business is subject to substantial additional monthly and other reporting obligations and oversight by creditors, interested parties, and the bankruptcy court. In addition, in many cases, a committee of unsecured creditors is appointed to act as representatives on behalf of all unsecured creditors. Attorneys and other professionals hired by the unsecured creditors’ committee are paid from the assets of the company, they are not paid by the members of the unsecured creditors’ committee.

In addition to reporting and oversight costs, Chapter 11 bankruptcies have been notoriously expensive because procedural requirements demand substantial attorney work, not only on behalf of the company, but also on behalf of the unsecured creditors’ committee and other parties involved in the Chapter 11 process. Procedural requirements, among many, include obtaining bankruptcy court approval for all non-ordinary business transactions and court approval of a comprehensive disclosure statement before it can be presented to creditors for a vote.

Although the facts and circumstances vary significantly for why a particular company might elect Chapter 11, cost alone has been a significant barrier for viable yet small businesses. At its core, Chapter 11 is designed to preserve the going-concern value of a company, preserve jobs, retain business for suppliers, and benefit the economy, while repaying creditors an amount that is greater than the liquidation value of the company assets. With a large portion of the U.S. economy based on small businesses, the streamlined procedures and resulting cost savings of the SBRA provide reorganization opportunities for small business that were not previously a realistic option.[1] 

The Small Business Reorganization Act

In August 2019, Congress passed the SBRA, which became effective February 19, 2020. The purpose of the SBRA is to make Chapter 11 reorganization faster and less expensive for small businesses. It has been characterized as a balance between Chapter 7 and Chapter 11. A new subchapter V added to Chapter 11, titled “Small Business Debtor Reorganization,” brings several changes beneficial to qualifying small businesses, allowing them to restructure while avoiding some of the costs of a traditional Chapter 11 bankruptcy.

Definition and Qualification of a “Small Business”

A small business debtor is an entity “engaged in commercial or business activities” that has 50% or more of its debt arising from those activities, and with total noncontingent, liquidated debts (both secured and unsecured) of no more than $2,725,625 (temporarily increased to $7,500,000 under the CARES Act, as discussed below).

Aside from the debt limit, the following companies may not file for bankruptcy under the SBRA:

  • Companies with affiliates that exceed the debt limit
  • Public companies or any affiliate of a public company
  • Shopping centers
  • Office buildings
  • Industrial/warehouse buildings
  • Apartment complexes
  • Any small business that generates substantially all of its gross revenues from the operation of a single real property or project (that has at least four residential units)

Small Business Benefits under the SBRA

The SBRA includes the following provisions applicable to qualifying small businesses:

  1. Assistance provided by a “standing trustee.” A qualified small business trustee (known as a “standing trustee”) or in some cases, a disinterested person, will be assigned to each case to monitor the debtor and “help ensure the reorganization stays on track.”[2] In small business cases, many of the company’s Chapter 11 obligations have been delegated to the standing trustee, easing the burdens on the company. The standing trustee’s fees are paid as part of the plan of reorganization—small business debtors are exempted from paying quarterly fees to the U.S. Trustee.
  2. No creditors’ committee costs. Unlike a traditional Chapter 11 proceeding, no creditors’ committees will be appointed unless ordered by the bankruptcy court for cause. This saves substantial money, because in a traditional Chapter 11, the debtor is required to pay the legal and other professional fees and costs of the creditors’ committee.
  3. Debtor retains control over the plan. Under the SBRA, only the debtor may file a plan, which must be filed within 90 days of the petition date (though there is a provision for extensions in appropriate circumstances). Additionally, the debtor generally does not have to file and first obtain court approval of a separate document referred to as a “disclosure statement.” Traditional disclosure statement requirements have been reduced, such that the debtor need only propose a plan containing a brief history of the company and its circumstances, a liquidation analysis, and a projection of the company’s ability to make payments under the proposed plan. This is another substantial cost saving difference over the traditional Chapter 11 process. Also eliminated under the SBRA is the provision that permitted creditors, under certain circumstances, can propose their own competing plan, which increased the litigation cost of the bankruptcy.
  4. Court can confirm the plan over creditor objections. Unlike in a traditional Chapter 11 bankruptcy, a court can confirm a plan under the SBRA even if creditors vote to reject the plan. If the court approves such a plan, then the company’s plan must pay to creditors an amount equal to all of its “disposable income” (i.e., income not needed for operation, preservation, or maintenance of the company’s business) generated over a three- to five-year period. The SBRA also allows owners of small business debtors to retain their ownership interest in the company provided the plan does not “discriminate unfairly” and is “fair and equitable” as to those creditor classes that do not vote in favor of the company’s plan.
  5. Administrative expenses can be paid over time. In traditional Chapter 11 proceedings, all administrative costs of the proceeding (including, for example, legal fees and fees for other professionals and advisors) must be paid on the effective date of the plan. Under the SBRA, the company may stretch those payments out over the term of the plan.
  6. Debtors can retain their pre-bankruptcy attorneys. In a traditional Chapter 11, an attorney who represented the company prior to bankruptcy would be precluded from representing the company in bankruptcy if any fees were owed to the attorney at the time of filing. The SBRA allows a company to continue to use pre-bankruptcy counsel, provided the unpaid fees do not exceed $10,000. The change is intended to reduce the cost of bankruptcy by allowing the company to continue to use counsel with institutional knowledge of the business.

Temporary Enhancements under the CARES Act

On March 27, 2020, in response to the global COVID-19 pandemic, Congress passed the CARES Act, a $2 trillion stimulus and relief package. As part of its relief, the CARES Act makes further significant—although temporary—changes to the SBRA.

Specifically, it increases the debt limit from $2,725,625 to $7,500,000, allowing many more small businesses to qualify for the protections of the SBRA. After one year, the increased debt limit will reset to $2,725,625.

Conclusion

The SBRA and the CARES Act make substantial changes to the Bankruptcy Code that will affect both debtors and creditors, and will make small business reorganization a more viable option for the numerous businesses struggling in the wake of COVID-19. For further guidance on the potential impact to or opportunities for your business, contact our bankruptcy professionals.

[1] According to J.P. Morgan Chase, over 99% of the United States’ 28.7 million firms are small businesses. The vast majority (88%) of employer firms have fewer than 20 employees, and nearly 40% of all enterprises have under $100,000 in revenue. Twenty percent of small businesses are employer businesses and 80% are nonemployer businesses. J.P. Morgan Chase, “Small businesses are an anchor of the US economy,” https://www.jpmorganchase.com/corporate/institute/small-business-economic.htm (last visited Apr. 6, 2020) (citing U.S. Census Bureau data).

[2] See Senator Chuck Grassley, Grassley, Bipartisan Colleagues Introduce Legislation to Help Small Businesses Restructure Debt (Apr. 9, 2019), https://www.grassley.senate.gov/news/news-releases/grassley-bipartisan-colleagues-introduce-legislation-help-small-businesses-0 (last visited Apr. 6, 2020).

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