The Small Business Reorganization Act of 2019 (SBRA) became effective on February 19, 2020, bringing with it a new reorganization tool for small business debtors: Subchapter V of the U.S. Bankruptcy Code. Subchapter V streamlines the Chapter 11 bankruptcy process for small business debtors, providing an alternative to the more time-consuming and costly reorganization of a traditional Chapter 11 case. It does so by employing a shorter timeline, imposing fewer burdensome requirements, and adding resources for small business debtors.
As Subchapter V is now one year old, this article highlights its benefits for small business debtors, reviews available data concerning its use so far, and addresses some of the issues it is generating in the courts.
Generally, a “small business debtor” is a business entity or individual “engaged in commercial or business activities” who has noncontingent, liquidated debts of not more than $2,725,625, at least 50% of which is business debt. The Bankruptcy Code excludes certain debtors from the small business designation, including (a) any debtor whose primary business is owning single asset real estate; (b) any member of a group of affiliated debtors that has aggregate debts in excess of the debt limit; (c) any corporate debtor subject to the reporting requirements of the Securities Exchange Act of 1934 (SEA); and (d) any debtor that is affiliated with an “issuer,” as defined in the SEA.
When Congress passed the CARES Act in 2020 in response to the COVID pandemic, it increased the Subchapter V debt limit to $7.5 million. While that increase was currently scheduled to expire on March 27, 2021, recently introduced bipartisan legislation would extend the increased Subchapter V debt limit through March 27, 2022.
The Subchapter V process resembles the streamlined Chapter 13 bankruptcy process that individuals have used to adjust and discharge their debts for many years. The benefits Subchapter V provides to the small business debtor1 include, among other things, that it:
The bankruptcy caseload statistics published by the U.S. courts do not separately classify Subchapter V cases, but data made available by the American Bankruptcy Institute (ABI) and Epiq show that Subchapter V has been popular with small businesses seeking to use Chapter 11:
Prior to Subchapter V becoming effective, there were estimates that approximately 40% of Chapter 11 cases in recent years would have qualified for Subchapter V.2 Consistent with those estimates, an analysis by Ed Flynn at the ABI showed that through October 19, 2020, approximately 36% of all Chapter 11 cases filed since Subchapter V became effective have been Subchapter V cases (excluding Chapter 11 cases filed in the three judicial districts in which the largest Chapter 11 cases are often filed, because the many related filings by corporate subsidiaries in those cases distort the statistics).3 Similarly, the ABI and Epiq data show that in December 2020, just under 36% of all Chapter 11 filings were Subchapter V cases.
As noted earlier, subject to pending legislation, Subchapter V’s $7.5 million debt limit is scheduled to expire on March 27, 2021, returning the debt limit to just over $2.7 million. The extent to which the reduction in the debt limit will reduce the percentage of Chapter 11 cases proceeding under Subchapter V is not clear. One analysis shows that six out of 22 Subchapter V cases in Delaware through October 31, 2020 (i.e., 27%), qualified based on the higher debt limit.
The SBRA appears to be achieving its purpose of streamlining small business bankruptcies. According to an analysis of a segment of Subchapter V cases filed from February 19, 2020, through September 30, 2020, approximately 20% of Subchapter V cases had confirmed plans, six times higher than the percentage for small business Chapter 11 cases that did not proceed under Subchapter V during the same period.5
Not surprisingly, given that the law is still so new, many of the court decisions concerning Subchapter V focus on the following threshold issues of eligibility and plan confirmation.
What does it mean to be “engaged in commercial or business activities?”
For a while, it appeared courts agreed that Subchapter V debtors were not required to be currently engaged in business activities. Some went so far as to say that simply reorganizing residual business debts in bankruptcy satisfied this threshold.6 However, in In re Thurmon, No. 20-41400, 2020 Bankr. LEXIS 3422 (Bankr. W.D. Mo. Dec. 8, 2020), the court disagreed with this broad interpretation.
The debtors in Thurmon were a retired couple who had sold the majority of their business months before filing bankruptcy. Although the business itself was still registered and owned a few assets, it had no employees, customers, or vendors, and the debtors had no intent to resume business activities.
Under the rulings in cases such as Wright and Blanchard, the debtors in Thurmon may well have qualified for Subchapter V. However, the court held that the debtors were not “engaged in” business simply because they were reorganizing business debts. The court surveyed case law interpreting similar language in different provisions of the Bankruptcy Code to conclude that the phrase “engaged in” means “to be actively and currently involved.”
Thurmon appears to be the minority view, but by creating a split in authority, it may result in fewer bankruptcy filers qualifying as small business debtors moving forward.
Can a debtor redesignate an existing bankruptcy case to Subchapter V?
Another frequent issue has been whether a debtor that filed a traditional Chapter 11 or Chapter 7 case can later elect to proceed in Subchapter V.
Courts facing this issue have acknowledged that nothing in the Bankruptcy Code prevents a debtor from amending its petition and redesignating its case to Subchapter V. However, Subchapter V imposes a shorter deadline to file a proposed plan of reorganization (90 days from the bankruptcy petition date) than traditional Chapter 11. Therefore, a debtor that seeks to redesignate to Subchapter V must either act quickly to meet that deadline or obtain an extension to avoid dismissal, which is only available when “the need for the extension is attributable to circumstances for which the debtor should not justly be held accountable.” 11 U.S.C. Section 1189.
In the cases of In re Seven Stars on the Hudson Corp., 618 B.R. 333 (Bankr. S.D. Fla. 2020), and In re Wetter, 620 B.R. 243 (Bankr. W.D. Va. 2020), the courts reached different conclusions as to what “justly accountable” means.
In Seven Stars, the debtor filed a Chapter 11 case in June 2019 but did not seek to redesignate it to Subchapter V until June 2020, four months after the SBRA became effective and well beyond Subchapter V’s 90-day plan deadline. The court found that the debtor’s inability to meet the deadline was due solely to its decision to try to redesignate only after the deadline had passed and, therefore, “it cannot be said that the need for an extension … is attributable to circumstances for which the debtor should not justly be held accountable.” The court therefore dismissed the case.
In Wetter, the debtor filed a Chapter 7 case in July 2019 but did not seek to convert it to Chapter 11 and elect Subchapter V until July 2020. The court wrote that the ruling in Seven Stars was “too rigid” and that the court can adjust the Subchapter V plan-filing deadline to run from the redesignation to Subchapter V. However, the court nonetheless denied the debtor’s bid to get to Subchapter V because he had played “fast and loose” in the case as to the facts of his financial circumstances and therefore “is not given the benefit of the doubt” as to the “justly accountable” standard.
The Wetter court noted that its experience had been that no one objects to a debtor’s redesignation to Subchapter V, even in cases that were filed before Subchapter V became effective. The court speculated that the efficiencies Subchapter V offers for both debtors and creditors might explain that general lack of opposition. It seems likely, then, that outcomes like those in Seven Stars and Wetter will be the exceptions, not the rule.
What is “fair and equitable treatment” for unsecured creditors?
To confirm a consensual Subchapter V plan, the debtor must meet the same requirements as confirmation of a traditional Chapter 11 plan (except the requirement that a debtor who is an individual must either fully pay unsecured claims or pay five years’ worth of disposable income toward those claims). The court can also confirm a nonconsensual, or “cramdown,” Subchapter V plan so long as the plan “does not discriminate unfairly, and is fair and equitable” with respect to each impaired class of creditors that has not accepted the plan.
Although fair and equitable treatment of non-accepting impaired creditors is also required in traditional Chapter 11 cases, Subchapter V defines the phrase differently with respect to unsecured claims. In Subchapter V, “fair and equitable” means that with respect to unsecured claims, the plan must provide that the debtor’s projected disposable income for a three- to five-year period will be applied to plan payments, or for the debtor to distribute an equivalent value of property under the plan. Further, the debtor’s financial projections must also show that there is a reasonable likelihood that the debtor will be able to make all payments under the plan, and the plan must provide remedies in case the debtor defaults on payments.
Two cases that involve the issue of fair and equitable treatment in Subchapter V are In re Pearl Resources, LLC, 622 B.R. 236 (Bankr. S.D. Tex. 2020), and In re Ellingsworth Residential Community Association, No. 6:20-bk-01346, 2020 Bankr. LEXIS 2897 (Bankr. M.D. Fla. Oct. 16, 2020).
In Pearl Resources, creditors objected to the proposed Subchapter V plan because, among other things, it “provides absolutely no specifics on the anticipated amount of Disposable Income, the dates when Disposable Income will be available, or even how Debtors will calculate or report Disposable Income.” The court nonetheless confirmed the plan, giving great weight to the uncontroverted testimony of the debtor’s managing member that it is reasonably likely that the debtors will generate sufficient income to pay claims in full within two years, failing which the debtor has sufficient assets that it can sell to pay claims in full.
In Ellingsworth, the court found that the proposed plan was fair and equitable based on testimony of the debtor’s president that the debtor, a homeowner’s association, could obtain $300,000 to pay into the plan via a special assessment to be approved by the debtor’s members. The court, however, also required the debtor to obtain the members’ approval of the assessment within a “reasonable time” after plan confirmation, failing which the debtor would be in default under the plan.
Courts have also decided other issues of eligibility for Subchapter V. For instance, in In re Serendipity Labs, Inc., 620 B.R. 679 (Bankr. N.D. Ga. 2020), the court ruled that “because a publicly traded company holds more than 20% of Debtor’s voting shares,” the debtor is affiliated with an “issuer” as defined in the SEA and therefore is ineligible for Subchapter V. The court rejected the debtor’s argument that the shares the court counted toward the 20% threshold were not “voting shares” because they did not allow the affiliate to vote on the debtor’s bankruptcy filing.
Further, in In re Parking Management, 620 B.R. 544 (Bankr. D. Md. 2020), the court determined that Paycheck Protection Program (PPP) loans and certain lease rejection claims are contingent debts and therefore do not count against Subchapter V’s $7.5 million debt limit. The court reasoned that PPP loans are forgiven if properly used and therefore the debtor’s liability for repayment is contingent upon misuse of the loan. It also found that because lease rejection must occur through court approval, any claims from the debtor’s lease rejections were contingent as of the petition date.
Subchapter V clearly has found a foothold with small business Chapter 11 filers and their advisers, and it seems likely to be a significant part of the bankruptcy landscape for the long term, even if the expiration of the $7.5 million debt limit meaningfully reduces the number of Subchapter V cases. Familiarity with Subchapter V and ongoing developments in the law related to it is therefore essential to the turnaround professional.
1 Two prior articles in the Journal of Corporate Renewal ably detail these and other advantages of Subchapter V: Jerrold L. Bregman, “New Law Puts Chapter 11 Bankruptcy Within Reach for Small Businesses,” May 2020; and Heidi J. Sorvino and Amy E. Vulpio, “What Middle Market Lenders Need to Know About Subchapter V,” October 2020.
2 Charissa Potts, “Key Facts About the SBRA,” ABI Journal, December 2019 (referencing ABI estimates); Bob Lawless, “How Many New Small Business Chapter 11s?” Credit Slips, Sept. 14, 2019.
3 Edward M. Flynn, “Subchapter V’s First 1,000 Cases,” ABI Journal, November 2020.
4 Teadra Pugh, “Analysis: Small Change to SBRA Makes a Big Bankruptcy Difference,” Bloomberg Law Analysis, November 30, 2020.
5 Clifford J. White III, “Small Business Reorganization Act: Implementation and Trends,” ABI Journal, January 2021.
6 See In re Wright, No. 20-01035, 2020 Bankr. LEXIS 1240 (Bankr. D.S.C. Apr. 27, 2020) (finding that a debtor seeking to address residual business debts was engaged in commercial or business activities); In re Blanchard, No. 19-12440, 2020 Bankr. LEXIS 1909 (Bankr. E.D. La. July 16, 2020) (allowing debtors to proceed in Subchapter V although some of their debts were from non-operating businesses).