Effective February 19, 2020, Congress added a new Subchapter V to Chapter 11 to make it easier for individuals and small business to seek relief pursuant to Chapter 11. This was long overdue. For years businesses and individuals were unable to reorganize under Chapter 11 because it was simply too expensive. Thus, many businesses simply had to liquidate and shut down pursuant to a Chapter 7 (Chapter 13 is only for individuals and has debt limits) where they could have otherwise been saved.
The enabling legislation which created Subchapter V is known as the Small Business Reorganization Act of 2019 (“SBRA”). Its stated purpose is to streamline the process by which small business debtors reorganize and rehabilitate their financial affairs. It is designed to make Chapter 11 more accessible to individuals and businesses by speeding up the process with lower costs, to allow businesses to keep operating which benefits not only the owners but employees, suppliers, customers, taxing authorities and other stakeholders who benefit from that business.
In order to obtain relief under Subchapter V an individual or business must first qualify. At least 50% of the business or individual’s debts must have arisen from commercial or business activities. The question is yet to be determined whether or not those business and commercial activities must still be ongoing, but early decisions indicate that the answer is “no”. In re Wright, No. 20-01035 (Bankr. D.S.C. April 27, 2020) (holding that the owner who personally guaranteed the debts nor the business needed to be currently engaged in business activities). It’s also worth noting that a Single Asset Real-Estate business does not qualify as a small business debtor. There are debt limits as well. As of the enaction date a debtor could not qualify to be a Subchapter V if its debts (with some exceptions) exceeded $2.7 million. However, on March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (a/k/a “CARES Act”) increased this amount to $7.5 million for one year. This was recently extended for another year set to sunset in March 2022.
How Does Chapter 11 Subchapter V Work?
Once an individual or business is deemed eligible and elects to be treated as a Subchapter V Debtor the ultimate goal is the same of any other Chapter 11 – a confirmed Plan of Reorganization or Liquidation (though to be fair oftentimes parties can resolve their differences once a case has been filed and a mutual agreement to dismiss without confirmation can be reached). The process though is much simpler than a traditional Chapter 11.
For example, there are no US Trustee fees in a Subchapter V. There is no requirement to appoint a creditors committee. It is easier to hire bankruptcy counsel as some of the requirements for retention have been modified. Importantly, only the Debtor can file a plan under Subchapter V and no disclosure statement is required. In a traditional Chapter 11 other parties, such as creditors, could file their own plan. Voting is also no longer necessary, mortgages on the debtor’s residence are subject to modification if they were business related, post-confirmation modification is easier, and the discharge requirements have been greatly enhanced (see below). Probably the most important change is the elimination of the absolute priority rule as a bar to confirmation. The absolute priority rule is too complex to go into here but trust us when we say that this is a big deal. This isn’t an exhaustive list, but note that all of this taken together, especially where there are not multiple plans pending confirmation, should and generally does result in a less expensive process.
One thing which is unique about Subchapter V is the mandatory appointment of a Trustee. Interestingly though that unlike a traditional Chapter 11 the Subchapter V trustee doesn’t operate the debtor’s business. Their role is shaping up to be a bridge between parties (sometimes referred to as a built-in mediator) but most importantly what they do depends on the type of plan that is proposed.
In a Subchapter V the plan can either be consensual or non-consensual. The former is where everyone agrees and the later is where the debtor forces plan on non-consenting parties. In a consensual plan the trustee’s services end upon substantial consummation (typically when payments to creditors begin). In a nonconsensual plan the trustee will make the payments to the creditors until it is completed. Note, that Debtors should be cautioned to not overuse the trustee largely because the Debtor has to pay for the Trustee! In most cases though trustee fees should be relatively modest as their duties mainly involve light supervision and monitoring of the case to confirmation. It remains to be seen though if and how this evolves over time.
The Plan & Subchapter V Discharge
One critical feature of Subchapter V is the ability to confirm a plan if there are dissenting votes. As stated earlier there are two types of plans, consensual and non-consensual. In the later confirmation is harder in a traditional Chapter 11 because at least one impaired class of creditors (e.g., secured, unsecured, etc…) must have a vote accepting the plan. Not so in a Subchapter V. A Subchapter V can be confirmed even if everyone votes against confirmation. The novelty and importance of this cannot be understated. For confirmation to occur in this instance the plan must be “fair and equitable”. True this is somewhat of an oversimplification, but a lengthy discussion of what “fair and equitable” is well beyond the scope of this article. So we can only touch on the basics here.
Essentially for a plan to be “fair and equitable” the creditors must receive the greater of either what they would have received if there was to be a liquidation of the assets or all of the debtor’s “projected disposable income” for a period of three years minimum to five years maximum. So how is projected disposable income calculated and how to you determine the length of the pan?
The later requirement is a bit more malleable and as of the writing of this article the case law is still unclear. The former however was defined by congress. The SBRA states that disposable income is income that is received by the debtor and that is not reasonably necessary to be expended for the maintenance or support of the debtor or a dependent of the debtor (individual cases) or payment of expenditures necessary for the continuation, preservation, or operation of the business of the debtor (businesses). As to the later, for businesses, the case law s still developing on this front and there may be a more specific test utilized in the future. But as of right now at least the general consensus is that these are ordinary, normal, and reasonable business expenses. Such as payroll, rent, marketing, supplies, and so on. Questions can arise however as to what is reasonable. For example, how much should the debtor be able to pay its owner? Some debtors, will want to pay their owner more than market rates and creditors may object because doing so would result in more money being made available for distribtions.
The Subchapter V is a powerful new tool that makes reorganization accessible to small businesses. We can tell you that the cases that we have done thus far would not have been possible but for Subchapter V. Those businesses were small businesses owned by regular people and we were able to reduce their overhead and streamline their operations. So far so good, they are thriving where prior to Subchapter V they would have almost certainly have failed.
The last thing that we want to mention, which comes up a lot, is the scenario where a business has debt, qualifies for a Subchapter V but those debts are personally guaranteed by the owner. What happens to the personal guarantee if the business files bankruptcy? The answer is that the business bankruptcy does not remove the personal guarantee of the individual. So the business can strip down its liabilities but the creditors will eventually look to the guarantor to make up the difference. The most effective way to resolve this is to have the individual either file his or her own Subchapter V, Chapter 7, or Chapter 13 as the case may be. If that is not an option the debt settlement is the best alternative.
Remember that you will need an attorney for Subchapter V of Chapter 11. We don’t say this because we are attorneys. We mean it. You can get away with a Chapter 7 without counsel if you are careful and a bit lucky. Not so in Chapter 13 or Chapter 11’s. I’m sure its happened but it is exceedingly rare. If you would like to determine if Subchapter V is right for you or your business contact us today!
About the Author: Robertson Cohen
Rob Cohen is a Managing Partner of Cohen & Cohen, P.C., serving clients in Colorado and Wyoming. He’s a Chapter 7 Bankruptcy Panel Trustee, certified mediator, and has administered over 8,000 Chapter 7 bankruptcy estates.