Alert 04.17.20
Navigating Bankruptcy Exposure for Landlords Arising from Anticipated Lease Terminations During COVID-19
Lease terminations may result in fraudulent transfer claims.
Alert
Alert
04.20.20
The Small Business Reorganization Act of 2019, which created Subchapter V of chapter 11 of the Bankruptcy Code, became effective on February 19, 2020 (11 U.S.C. §§ 1181-1195 “Subchapter V”). Subchapter V was intended to mitigate perceived challenges faced by small business debtors, with no more than $2,725,625 in debt, in traditional chapter 11 cases. In response to the COVID-19 crisis, the CARES Act expands Subchapter V eligibility for a period of one year (or longer if extended by Congress) by increasing the cap to $7,500,000 in aggregate secured and unsecured non-contingent and liquidated debt. Widespread distress and decreased asset values along with the subchapter’s debtor-friendly rules likely will make Subchapter V an even more attractive option for larger than originally-contemplated businesses who seek to benefit from its short timeline (debtors must file plans of reorganization within 90 days), its reduced administrative expense (there is no disclosure statement to prepare and pay for, no creditors’ committee to fund, and no administrative fees to be paid to the United States Trustee), and its elimination of the “absolute priority” rule (owners can retain their equity in a Subchapter V small business over the objection of a class of unsecured creditors, without paying those creditors in full).
This alert first covers an eligibility issue that may be exacerbated by the availability of Subchapter V to larger business, then, for context, summarizes key features of Subchapter V, and finally identifies several chapter 11 creditor protections that remain unaltered by Subchapter V.
Eligibility for Subchapter V
To be eligible for Subchapter V, a debtor must meet the definition of a “small business debtor” and elect to be a Subchapter V debtor. With its CARES Act amendment, Bankruptcy Code section 101(51D) defines a small business debtor as a business:
engaged in commercial or business activities (including any affiliate … and excluding a person whose primary activity is the business of owning single asset real estate) that has aggregate noncontingent liquidated secured and unsecured debts … in an amount not more than $7,500,000 [previously $2,725,625] (excluding debts owed to 1 or more affiliates or insiders) not less than 50 percent of which arose from the commercial or business activities of the debtor.
The definition of a small business debtor, thus, excludes debts that are contingent (e.g., a claim based on a guarantee of someone else’s not-in-default debt) or unliquidated (e.g., a tort claim), likely because non-contingent, liquidated debts are a readily available measure of a debtor’s size. See In re Hustwaite, 136 B.R. 853, 855 (Bankr. D. Or. 1991) (concluding that Congress was concerned about “delay when it limited the kinds of debts to be included in determining eligibility….”). If not, for example, a “mom & pop” shop, with contingent liability for a slip and fall claim, might not be eligible for Subchapter V, as Congress intended.
Although there was always a risk that debtors might try to classify certain debts as contingent or unliquidated to squeeze into Subchapter V, the increase of the non-contingent, liquidated cap makes it possible for even larger companies, with significant contingent and unliquidated debts that might be able to reorganize under a traditional chapter 11, to qualify as a “small business debtor.” For example, a midsize business—with over 100 employees and $20 million in annual revenue—that is subject to $150 million in litigation claims, would qualify for Subchapter V as long as its noncontingent and unliquidated claims (e.g., trade and funded debt claims) total less than $7.5 million.
Whether larger debtors with significant self-designated contingent and unliquidated debt that try to shoehorn themselves into Subchapter V relief will succeed is unclear. Parties have had some success challenging a debtor’s small business designation in pre-Subchapter V cases. See, e.g., Coleman Enters., Inc. v. QAI, Inc. (In re Coleman Enters., Inc.), 275 B.R. 533, 539 (B.A.P. 8th Cir. 2002) (finding small business election void where noncontingent liquidated debts exceeded statutory ceiling); see also In re Buis, 337 B.R. 243, 250-52 (Bankr. N.D. Fla. 2006) (dismissing chapter 13 filing for bad faith because “timing of the bankruptcy filing was an ultimately futile attempt to keep the debtors eligible to file for relief under chapter 13….”). However, given its recent enactment, there is no case law yet testing a debtor’s designation in the Subchapter V/post-CARES Act context. The United States Trustee, which serves as the government watchdog in Bankruptcy Court, will likely continue to review actively the legitimacy of a debtor’s designation/non-designation and respond as it deems appropriate.1 And the Bankruptcy Rules give parties thirty days from the section 341(a) creditors’ meeting, or, if later, thirty days from the filing of an amended designation, to object to a Subchapter V designation. See Fed. R. Bankr. Proc. 1020(b).
Key Features of Subchapter V
Subchapter V modifies or eliminates many traditional chapter 11 requirements that made obtaining plan confirmation difficult and expensive for small businesses, including:
In a Subchapter V case, as long as unsecured creditors are to be paid the debtor’s “disposable income” for a period of three years (or up to five years if extended by the court), equity holders will continue to own and manage their business, even where creditors all vote against the plan and object to confirmation. Disposable income includes income that is not reasonably necessary to be expended “for the payment of expenditures necessary for the continuation, preservation, or operation of the business of the debtor.” 11 U.S.C. § 1191(d)(2).
Continuing Creditor Protections
Although Subchapter V provides small business debtors with substantial benefits, several important creditor protections in chapter 11 remain applicable. These include, without limitation:
Each of these provisions, in appropriate circumstances, may be used by creditors to secure better treatment than that being offered by a Subchapter V debtor. Because Subchapter V is so new, however, there is not yet any case law guidance on how these creditor protections will be used and applied under the new law.
Conclusion
The debtor-friendly provisions of Subchapter V will expedite and decrease the costs of the chapter 11 process for small businesses. As companies continue to struggle with financial distress from COVID-19 and otherwise, we expect many businesses will utilize Subchapter V to reorganize. Some larger businesses will claim eligibility to fit within the post-CARES Act debt cap to take advantage of the revised “cramdown” rules for unsecured classes, the ability to spread out administrative expense payments, and the inability for other parties to file a competing chapter 11 plan. For debtors, Subchapter V presents an opportunity to save the business and continue ownership and management. For creditors, however, a fast-paced restructuring without certain creditor protections traditional to chapter 11 presents many potential pitfalls, although some basic creditor protections in chapter 11 remain unaltered by Subchapter V.
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1. See Adam D. Herring et al., New Laws, New Duties: The United States Trustee Program’s Implementation of the HAVEN Act and the Small Business Reorganization Act, ABI Journal (Vol. XXXVIII, No. 10, Oct. 2019), available at https://www.justice.gov/ust/file/abi_201910.pdf/download. We note that if a debtor qualifies as a “small business debtor” but does not elect Subchapter V treatment, the debtor still may reorganize under the small business debtor rules in effect since 2005. See id. at 2. We are aware of at least one case where, prior to the enactment of Subchapter V, the United States Trustee successfully moved to have a debtor deemed a small business debtor, where the debtor listed disputed unsecured debts exceeding $15 million, but did not designate itself as a small business debtor under other provisions of the Bankruptcy Code. Whether the same opportunity for the United States Trustee exists to try to compel a Subchapter V election is untested.
2. See Pub. L. No. 116-54 § 4(b)(3) (amending 28 U.S.C. § 1930(a)(6) to exclude cases under subchapter V from cases responsible for payment of quarterly fees). For most pre-Subchapter V small business cases, fees to the U.S. Trustee could range from several hundred to several thousand dollars per quarter until the case is closed, dismissed or converted to a chapter 7 liquidation. See Chapter 11 Quarterly Fees, U.S. Tr. Program, https://www.justice.gov/ust/chapter-11-quarterly-fees (last visited Apr. 15, 2020).
3. A contract is executory and can be assumed or rejected under the Bankruptcy Code if, as of the commencement of the bankruptcy case, material performance remains due from both the debtor and non-debtor parties. See Regen Capital I, Inc. v. Halperin (In re U. S. Wireless Data, Inc.), 547 F.3d 484, 488 n.1 (2d Cir. 2008) (an executory contract is "a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other." (citation omitted)).
4. Typically, having any portion of a prepetition claim treated as an administrative expense or a contract assumed requiring arrearages to be paid and future breach claims to be treated as administrative expense claims is welcome news for a creditor, and may encourage a creditor to continue to extend credit to a struggling company. If, however, Subchapter V debtors have the ability to defer payment of administrative expenses under 11 U.S.C. § 1191(e), as discussed above, a creditor may have less incentive to transact with a small business that is likely headed for chapter 11 if that credit extension need not be paid in full at the time of confirmation for the debtor to be able to confirm a plan.