CARES Act Enhances Newly Enacted Small Business Bankruptcy Provisions

Joe Foster Headshot
Joseph A. Foster
Director, Corporate Department
Christopher M. Dube
Director, Corporate Department
Published: McLane.com
June 1, 2020
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Many small businesses are facing financial challenges; some because of long-standing issues, others as a result of the sudden impact of COVID-19.  Survival in many cases will require negotiating with lenders, trade creditors, landlords, and employees with out-of-court restructurings.  Others, however, will need the protections and tools provided under the United States Bankruptcy Code and will need to file a petition for relief and in order to effectively reorganize.

Chapter 11 as a Resource

Chapter 11 of the Bankruptcy Code was intended to provide an opportunity for businesses to restructure bank debt, discharge trade debt, and reject burdensome contracts and leases.  The “automatic stay” imposed by Section 362 of the Bankruptcy Code provides breathing room to reorganize by suspending collection activity and litigation against the debtor.  The Bankruptcy Code was also intended to provide an opportunity to sell the business as a going concern, free and clear of liens, claims, and encumbrances; the “free and clear” nature of a sale by a bankruptcy estate can make the distressed business a more attractive acquisition opportunity for potential buyers.

Enactment of the Small Business Reorganization Act

Since its enactment, it became clear that in practice chapter 11 was simply too long and expensive a process for most small businesses. The obligations placed on the business and its counsel, the statutory hurdles to confirm a plan, and the litigious nature of the process prevented many small businesses from filing for bankruptcy and those that did from successfully reorganizing.

Recognizing that chapter 11 was not an effective resource for small businesses, Congress enacted the Small Business Reorganization Act (the “SBRA”) which amended the Bankruptcy Code by adding subchapter V to chapter 11.  The SBRA became effective on February 19, 2020.  The SBRA is designed give the small business more control of the bankruptcy process and to streamline the process by eliminating the many statutory hurdles that previously made reorganization difficult to achieve.

CARES Act Expansion of the Definition of “Small Business Debtor”

Subchapter V originally only applied to businesses with aggregate non-contingent, liquidated secured and unsecured debts up to $2,725,625.  The recently adopted CARES Act increased the threshold to $7,500,000.  That increase sunsets on March 26, 2021.  While that date could be extended, if you are considering using the Bankruptcy Code to reorganize your small business, then you should keep that date in mind.

Benefits of Chapter 11, Subchapter V

Some of the benefits of new Subchapter V include:

  • Only the small business debtor has the authority to propose a plan of reorganization (a “Plan”).  This avoids creditors holding out (either by not engaging or by taking unreasonable positions) until a time when they can propose a competing Plan.
  • In most cases the debtor will not be required to file a disclosure statement (a detailed description of the Plan) in addition to the Plan.  This avoids additional time and expense of preparation and seeking court approval.
  • The role of the Trustee, in large part, is to facilitate the process of reaching a consensual plan.  It is anticipated that trustees appointed to Subchapter V cases will have experience relevant to commercial reorganizations.
  • No quarterly fees need to be paid to the United States Trustee.  This avoids what can be a significant drain on the small business debtor’s cash flow during the pendency of a case.
  • A committee of unsecured creditors will not be formed in most cases.  This will relieve the debtor of the cost of committee counsel which can be a substantial burden.

Most notably, the SBRA modified Plan confirmation requirements in ways that are expected to greatly enhance the chance the Debtor’s Plan is approved.  For example, previously a class of impaired creditors needed to vote in favor of the plan which often led to the business being forced to agree to pay more than it could reasonably afford.  Also, before the SBRA the so-called “absolute priority rule” prevented an owner, absent the contribution of cash or other significant “new value,” from retaining ownership over the objection of a creditor whose class would not be paid in full under the Plan.

A Plan must still meet a number of statutory requirements, including that it is “fair and equitable,” to be approved by the court.  A plan is deemed fair and equitable if it dedicates all of the businesses’ “disposable income” to obligations under the Plan over a three to five year period. Disposable Income is broadly defined to mean, in relevant part, income received by the business not reasonably necessary to be expended for the continuation, preservation, or operation of the business.  In essence, the intent is to enable a business owner to retain ownership in the business, earn a reasonable living, and responsibly run the business provided the business pays over net income to its creditors.

New Subchapter V should make it much easier and quicker for a small business to reorganize under the Bankruptcy Code.  While bankruptcy rarely should be a first choice for a struggling business, the new Subchapter V provides important tools in the tool box to consider.  The expansion by the CARES Act of who qualifies as a “small business debtor” makes those tools available to a larger number of struggling small businesses.