The Small Business Reorganization Act: How Subchapter V Election Changes A Small Business Debtor’s Bankruptcy Filing

This article will address a new option for small businesses seeking bankruptcy help. A small business debtor typically files under Chapter 11 of the United States Bankruptcy Code. A Chapter 11 bankruptcy includes a plan of reorganization that allows filers to work out a repayment plan with their creditors. 

Under the relief offered by the new Subchapter 5 of the Small Business Reorganization Act (SBRA) of 2019, small businesses are permitted to go through a less complicated reorganization process under Chapter 11 that may better suit their financial needs. Additional relief provided by the recently passed CARES Act due to COVID-19 temporarily expands the definition of small business debtors to include some larger companies.

Why Would a Small Business File Bankruptcy?

Due to the significant impact that COVID-19 is having on most businesses, many small business debtors are choosing to file bankruptcy. In cases where the business is failing, the small business debtor may file a Chapter 7 bankruptcy to close their business as reorganization may not be an option for their particular circumstances. Whether a small business debtor chooses reorganization or to close, it is good to know there are debt relief options available for those suffering huge financial losses as a result of the COVID-19 pandemic. Additionally, the Coronavirus Relief Aid, Relief and Economic Security (CARES) Act temporarily expands eligibility under the SBRA so that larger companies can qualify for certain debt relief options ordinarily only available to small business debtors. This means they can file under Subchapter 5 of Chapter 11 even with significant amounts of noncontingent and unliquidated debts.

What is the Small Business Reorganization Act of 2019?

The Small Business Reorganization Act of 2019 was passed by Congress as an alternative to the standard Chapter 11 case for small business debtors. SBRA was signed into law on August 23, 2019, and it went into effect on February 19, 2020. Before this law was passed, small business debtors often struggled with reorganizing under a traditional Chapter 11 bankruptcy plan. Many small business debtors were not successful in reorganizing because of the significant costs and administrative burdens associated with this process. Filing a Chapter 11 bankruptcy is very expensive and time consuming for a small business. This is one main reason many small businesses elect to pursue a Chapter 7 bankruptcy instead, as this liquidation process avoids the administrative expenses and financial burdens of a Chapter 11 bankruptcy.  

Shortly after the SBRA went into effect, the coronavirus pandemic sent shock waves through the economy, which led Congress to pass The Coronavirus Relief Aid, Relief and Economic Security (CARES) Act. The CARES Act was signed into law on March 27, 2020. This new law amended the Bankruptcy Code to temporarily (for one year) expand eligibility under the SBRA so that larger companies can qualify as small business debtors. Larger entities can now file under Subchapter 5 of Chapter 11 even with substantial noncontingent and unliquidated debts to manage. The CARES Act amendment redefined a small business debtor as a business engaged in commercial or business activities with no more than $7,500,000 in aggregate noncontingent liquidated secured and unsecured debts.  Before this amendment, the previous amount was $2,725,62, so this change gives larger companies access to the streamlined bankruptcy process afforded by Subchapter 5.  

This is Still a Chapter 11 Case

You may be wondering how the SBRA works to give the small business debtor some relief from the traditional burdens associated with the Chapter 11 bankruptcy process. The small business debtor will still file a voluntary bankruptcy petition under Chapter 11 but will now be permitted to opt-in or elect subchapter 5  on their paperwork. Attached to the petition must be the most current federal tax return, cash-flow statement, current balance sheet, and statement of operations. Filing a Subchapter 5 enables you to be a debtor in possession of your business and its obligations. You will continue to manage the business but now you will need to report on business activities. In addition, you will report on the payment of expenditures. 

Small business debtors are still required to complete a proposed plan for reorganization and a disclosure statement as they do in a traditional Chapter 11 case. A United States Trustee will oversee the bankruptcy case and remove the business owner from the possession of the business if needed. The process is not as complex as a standard Chapter 11 reorganization. However,you will still need the assistance of a bankruptcy attorney or law firm to represent you to be successful in discharging your debt. Also, similar to a traditional Chapter 11 case, once you receive your plan confirmation and the obligations under your plan are met, the Standing Trustee will grant a discharge of your debts.  

How is a Subchapter V Case Different From a Chapter 11?

Under the SBRA, both eligible individuals and business entities may be classified as small business debtors. The law also modifies the real estate exclusion in Chapter 11 by making a debtor whose primary activity is owning or operating more than one property eligible for Subchapter 5. The SBRA makes several changes to the Bankruptcy Code that streamline the reorganization process for small business debtors. This new streamlined process reduces the time and administrative burdens that existed before SBRA became law.  

Absolute Priority Rule Waived

The single biggest difference between the Subchapter 5 case and a traditional Chapter 11 case is that the absolute priority rule is waived. This rule decides the order plan payments are made in the reorganization process. The standard underlying the absolute priority rule is the term “fair and equitable” which means creditors who have security interests or higher priority should not accept less than full compensation while “lesser” creditors may receive lesser compensation or retain interests. To be fair and equitable, the absolute priority rule says payments under the plan are paid as follows:  First, secured claims, then unsecured claims, and then interests like shareholders or equity holders. If a business is liquidating its assets in order to settle claims, secured claims take priority over unsecured claims. The result is secured creditors may be paid in full while unsecured creditors may not. Creditors who receive less than what they owed are known as impaired creditors. Anything left will then be paid to equity holders. So you can see how a small business debtor may lose equity in their business using this rule. However, by waiving absolute priority under Subchapter 5, a business owner can retain the equity in their business while also presenting a reorganization plan without paying all the impaired creditors who may object to the plan. 

No Competing Plans and Limited Use of Creditors’ Committees

Subchapter 5 also differs from the traditional Chapter 11 process with respect to creditors’ committees. They play a major role In Chapter 11 cases, where they are appointed by the trustee and consist of unsecured creditors with the 7 largest unsecured claims against the debtor. They have duties that include consulting with the debtor in possession regarding the administration of the case and participating in formulating and voting on a reorganization plan. The creditors’ committees may also investigate the debtor’s conduct and business operations. The costs for the work done by the committee members and their legal counsel are paid by the business debtor. However, with a Subchapter V, there is limited use of the creditors’ committees, so no competing reorganization plan is permitted and the expense to the debtor is greatly reduced. Creditors’ committees are formed only if there is cause such as mismanagement. Small business debtors have the right to file a reorganization plan during the first 90 days or as extended by court order. This reorganization plan does not have to be approved by the impaired unsecured creditors. However, the debtor’s plan must include a brief history of business operations, a liquidation analysis, and projections that illustrate how the obligations under the plan can be met.  

New Definition of Disposable Income

Subchapter 5 also differs from Chapter 11 in defining the disposable income of the debtor.  Disposable income under Subchapter 5 is redefined to as all funds not needed to pay reasonable expenses. These expenses include those necessary to support and maintain the small business debtor and satisfy domestic support obligations. Under the new definition, the disposable income excludes funds needed to operate, preserve, or continue the business 

All projected disposable income of the debtor remaining after expenses are accounted for is used to pay creditor claims. This is different from Chapter 11, which does not require all projected disposable income be used to pay creditors. Also, typically in Chapter 11, administrative expenses are paid at confirmation. In contrast, the small business debtor can pay administrative expenses over the years of the plan under Subchapter 5. Once the business owner completes all plan payments, their debts are discharged.   

The Appointment of Subchapter V Trustee in All Cases

Another major difference between the traditional Chapter 11 process and Subchapter 5 is the appointment of a trustee. In a regular Chapter 11, a trustee may be appointed when there is cause like fraud or gross mismanagement of a business or if a committee elects to have one oversee the process. By contrast, the Bankruptcy Code requires that a trustee be appointed in all Subchapter 5 cases. This trustee is referred to as the standing trustee whose duties include overseeing the bankruptcy case and collecting plan payments. The standing trustee attends the mandatory 60-day status conference. If the small business debtor loses their possession status, then the duties of the standing trustee expand. The primary role of the standing trustee is to act as a facilitator between the small business debtor and its creditors to reach consensus on a plan for reorganization. Compensation to the standing trustee is made in the form of an administrative expense in the amount of 5% of the total plan payments.  

Conclusion

The SBRA creates a subchapter to Chapter 11 that is designed to allow small business debtors an alternative to large and expensive Chapter 11 cases. Electing Subchapter 5 removes many of the financial barriers and administrative burdens faced by small business debtors in a typical Chapter 11 case. While Subchapter 5 streamlines the Chapter 11 bankruptcy process, you will still need an attorney to successfully complete this bankruptcy successfully, as it is a complicated process.