Subchapter V Offers a Lifeline for Small Businesses
The Bencher—November/December 2021
By Kristen E. Burgers, Esquire
According to the 2020 Small Business Profile published by the Office of Advocacy for the U.S. Small Business Association (SBA), the United States has 31.7 million small businesses, which account for 99.9% of all U.S. businesses. These small businesses employ 60.6 million people, or 41.7% of the private workforce. Businesses with 20 to 99 employees employ the most people. The SBA defines “small business” as an independent business with fewer than 500 employees.
Small businesses have been hit particularly hard by the COVID-19 pandemic. Although complete statistical data is not yet available, in its May 2021 Economic Bulletin, the SBA noted that the closure of small businesses in the second quarter of 2020 was a historic high and that over 14.7 million net jobs were lost during the first half of 2020.
Small businesses have always faced challenges due to their size and economic vulnerability. Larger firms can often weather fluctuations in the economic cycle—and have more tools available to help them do so—but small businesses often do not have the financial and other resources to help them stay afloat for long periods during downturns.
In the most difficult times, large businesses might elect to reorganize under Chapter 11 of the United States Bankruptcy Code. A traditional reorganization under Chapter 11 of the Bankruptcy Code was not an option for many small businesses, however, as it is expensive and inefficient, with many layers of administrative burdens and costs. In addition, the Chapter 11 process may move too slowly to allow the business to reorganize successfully. Because of the inefficiency, cost, and administrative burden, small businesses often resorted to out-of-court workouts and restructurings or, when their options ran out, simply closed their doors or filed for a liquidation under Chapter 7 of the Bankruptcy Code.
The Small Business Reorganization Act of 2019
Congress remedied this situation with the passage of the Small Business Reorganization Act of 2019 (SBRA), which went into effect February 19, 2020. As originally enacted, the SBRA allows for a less costly and more efficient streamlined Chapter 11 process, commonly known as “Subchapter V.” In a Subchapter V bankruptcy, the confirmation process for the debtor’s plan of reorganization is much faster and straightforward than in a traditional Chapter 11 bankruptcy. Only the debtor may submit a plan, and the plan must be filed within 90 days of the filing of the bankruptcy petition. The debtor is not required to file a disclosure statement with the plan. The disclosure statement is a lengthy, often complex document intended to explain the plan in layman’s terms so that creditors have adequate information to determine whether or not to vote to accept the plan. Disclosure statements in traditional Chapter 11 bankruptcies are often more than 50 pages, with voluminous attachments.
Plans under Subchapter V also have less stringent requirements. Plans are generally three years long, as opposed to the five-year plan commonly seen in traditional Chapter 11s. In a traditional Chapter 11, the debtor’s plan must have the support and affirmative vote of at least one class of “impaired” creditors (i.e., creditors whose rights are altered under the plan) in order to be confirmed. In a Subchapter V, a debtor may confirm its plan regardless of whether an impaired class of creditors has voted in favor of the plan, so long as the plan does not “discriminate unfairly” and is “fair and equitable,” with respect to each impaired class of claims or interests.
A plan is “fair and equitable” under the SBRA if it provides that (i) all projected disposable income of the debtor for three years (or such longer period the bankruptcy court may fix, but not to exceed five years) is applied to make payments under the plan or (ii) the value of all property to be distributed under the plan during its three- to five-year duration has a value that is not less than the debtor’s projected disposable income during that same time period. The SBRA defines “disposable income” as income not reasonably necessary for the maintenance and support of the debtor and his or her dependents, payment of domestic support obligations, and payments necessary for the continuation, preservation, or operation of the business of the debtor. It is thus possible for a small business debtor to confirm a Subchapter V plan without acceptance by any class of creditors.
The SBRA also reduces the administrative costs and burdens for small business debtors. In a traditional Chapter 11, the Office of the United States Trustee (OUST) has the authority to appoint committees to represent the interests of general unsecured creditors and, in the OUST’s discretion, other groups of creditors or interest holders with a significant stake in a Chapter 11 case. All costs associated with these official committees are borne by the debtor, including the committee’s legal fees, financial adviser fees, and other expenses. In a Subchapter V bankruptcy, the OUST will not appoint an official committee of unsecured creditors unless the bankruptcy court orders the appointment of a committee for cause. The OUST will, however, appoint a Subchapter V trustee. While the role of the Subchapter V trustee is still evolving, this individual functions as a resource for the debtor and creditors to resolve contested matters during the plan confirmation process and oversees payments made pursuant to the plan.
Modifications to the SBRA to Address the COVID-19 Pandemic
The SBRA went into effect in February 2020, just as the COVID-19 pandemic took hold and caused the widespread closure of businesses. Congress recognized that Subchapter V bankruptcy could offer a lifeline to small businesses affected by the pandemic and enacted several modifications to the SBRA to make it even more accessible.
On March 25, 2020, Congress passed the Coronavirus Aid, Relief and Economic Security Act of 2020 (CARES Act), the $2 trillion stimulus bill intended to help businesses, families, and individuals through the financial crisis created by the COVID-19 pandemic. The CARES Act established special loan programs and granted other concessions to businesses in financial distress as a result of the pandemic, such as the Payroll Protection Program. The CARES Act also included several meaningful modifications to the Bankruptcy Code and the SBRA.
Perhaps most importantly, the CARES Act increased the eligibility ceiling for debtors under SBRA. As initially enacted, the SBRA limited eligibility for Subchapter V to businesses with less than $2,725,625 in debt. The CARES Act increased this ceiling to $7,500,000. As a result of this nearly three-fold increase, thousands of additional businesses are eligible for SBRA’s many benefits. This increase was initially set to expire one year after the enactment of CARES; however, it was extended through March 27, 2022, with the COVID-19 Bankruptcy Relief Extension Act.
Based on statistics from Bloomberg Law (https://news.bloomberglaw.com/bloomberg-law-analysis/analysis-four-statistical-snapshots-of-subchapter-vs-1st-year?context=article-related), Subchapter V’s first year of enactment has been a success. The first Subchapter V case was filed in the Middle District of Tennessee on February 19, 2020. In the following year, 1,643 bankruptcy cases were filed pursuant to Subchapter V or converted to a case under Subchapter V. The greatest activity for Subchapter V filings occurred from August 19, 2020, to November 18, 2020, with 506 Subchapter V bankruptcy cases filed. This represented an almost 20% increase from the previous 90-day period, which is likely attributable to the cumulative effects of COVID-19 closures and the increased eligibility ceiling. In contrast, during the same time period, Chapter 11 filings increased by only 14.5%.
As with any new area of law, bankruptcy judges and practitioners alike are navigating unchartered territory in Subchapter V and setting boundaries and adding clarity through litigation and judicial opinions. Notwithstanding the increased debt limits, eligibility for SBRA continues to be one of the most widely-contested issues. In particular, courts have grappled with whether the Bankruptcy Code’s definition of a debtor as a person “engaged in commercial or business activities” requires the business to be operating at the time of the bankruptcy (see In re Pearl Res., 2020 Bankr. LEXIS 2683, *17-19 (S.D. Tex. Sept. 30, 2020) (holding that a business does not have to be operating at the time of filing); In re Blue, Case No. 21-80059 (Bankr. M.D.N.C. May 7, 2021) (holding that debt from a defunct business can help an individual qualify for Subchapter V).
The issue of whether a debtor has to be operating at the time of filing is particularly important given that many businesses were forced to close during the COVID-19 pandemic and may not have ever returned to pre-pandemic business operations. Confirmation of a Subchapter V plan over the objections of creditors (in bankruptcy terminology, a “cramdown”) is another area that has generated judicial opinions. Judge Eduardo V. Rodriguez of the U.S. Bankruptcy Court for the Southern District of Texas issued a thoughtful memorandum opinion discussing the requirements for cramdown for Subchapter V plan confirmation that has provided guidance in this area. See In re Pearl Res., 622 B.R. 236, (S.D. Tex. 2020).
While SBRA will likely generate more litigation as the number of Subchapter V bankruptcy cases increases, Subchapter V in its first year has proven itself to be a valuable and useful tool for small businesses facing financial distress. As the lasting effects of the COVID-19 pandemic continue to rise to the surface, small businesses and their counsel should consider a Subchapter V bankruptcy as among the most valuable tools in their toolbox.
Kristen E. Burgers, Esquire, is a partner in the law firm of Hirschler Fleisher in Tysons, Virginia. She is president of the Congressman Walter Chandler American Inn of Court in Washington, DC.