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SMALL BUSINESS REORGANIZATION ACT OF 2019

SMALL BUSINESS REORGANIZATION ACT OF 2019 (H.R. 3311) SIGNED INTO LAW ON AUGUST 23, 2019, TAKES EFFECT ON FEBRUARY 19, 2020

On August 23, 2019, the Small Business Reorganization Act of 2019 (“SBRA”) was signed into law.  The SBRA becomes effective 180 days later, on February 19, 2020 and creates a new “Subchapter V” in Chapter 11 of the Bankruptcy Code.   This new law fundamentally alters debtor-creditor relationships sharply in favor of business debtors by likely  eliminating the Absolute Priority Rule, which previously required full payment to unsecured creditors.   Although the law is limited to businesses whose debts are less than $2,725,625, many businesses with debts far in excess of this amount are likely to qualify by paying down debts at negotiated discounts and because the law does not count “contingent” and “unliquidated” debts in calculating total debts.  Debts arising from tort claims may, at least until judgment, be “unliquidated.”  Further, if a corporate entity is current on its payments then a guarantor’s liability may be “contingent.”   These debts are not included in calculating the $2,725,625 eligibility requirement.

 

An in-depth analysis of SBRA follows, but it is critical that businesses know up front that any business considering a bankruptcy case today should, if they might qualify for Subchapter V, delay their plans until late February.  Filing today and obtaining a discharge will preclude obtaining a discharge in a subsequent Subchapter V filing for up to eight years.  

  1. Elimination of Absolute Priority Rule For Unsecured Creditors

            The new law is an earthquake in debtor-creditor relationships because it appears to eliminate the  Absolute Priority Rule (“APR”) with respect to unsecured creditors.  The APR provides that a debtor must pay unsecured creditors in full if it wishes to retain ownership of its assets.    In the alternative, a debtor can, under existing law, keep ownership of assets without paying creditors in full only if a) at least one class of impaired creditors votes to accept the plan and b) the debtor pays “new value” in immediate cash and in a substantial amount.   For years debtors (most of whom have no access to immediate and significant amounts of cash) have sought to buy back ownership of their business and assets by providing new value in the form of payments over a period of years.  Those efforts have not succeeded because of the immediacy requirement of current law.  This "new value" requirement is a hurdle too significant for debtors without wealthy relatives to surmount, and is the reason that the vast majority of Chapter 11 cases are ultimately converted to Chapter 7 liquidation proceedings.   

            It is also critical to note that the APR requires that the new value contribution be reasonably equivalent to the business interest retained, and that the business be valued as a going concern.   Going concern valuations can be quite high, and this has served as an impediment to confirmation for many debtors.

 

            The SBRA also eliminates the requirement that any class of creditors vote to accept the plan of reorganization. However, there are significant advantages to obtaining such consent which are discussed below. 

 

     2.    Absolute Priority Rule Remains In Effect For Secured Creditors

            The Absolute Priority Rule remains in existence for secured creditors.    It is important to note that the property upon which a lien is obtained must have equity because from a bankruptcy perspective a lien is only ‘real’ if there is equity to support it.  11 U.S.C. §506 allows a creditor’s claim to be split into secured and unsecured portions based on the amount of equity in the collateral.  

      3.  Debtors Must Pay Their Disposable Income To Creditors For 3 to 5 Years

The SBRA requires debtors to pay their “disposable income” for a period of three to five years to creditors.  “Disposable income” is defined as:

“the income that is received by the debtor and that is not reasonably necessary to be expended—

(1) for—

(A) the maintenance or support of the debtor or a dependent of the debtor; or

(B) a domestic support obligation that first becomes payable after the date of the filing of the petition; or

(2) for the payment of expenditures necessary for the continuation, preservation, or operation of the business of the debtor.”

          

      4.   Home Mortgage Debt Can Be Modified

            Under current law debts secured only by a debtor's home generally cannot be modified in bankruptcy.  In a substantial break from this, the Small Business Reorganization Act specifically allows mortgages secured by a residence to be modified if the mortgage was taken for the purpose of financing the debtor's business.  11 U.S.C. §1190(3).  So, for example, if a businessperson has a $300,000 second-position mortgage against their home and the equity in their home is only sufficient to support $200,000 of that, under the new bill the $200,000 could be paid over a significant period of time (e.g., 15 years) while the unsecured part could be treated like all other unsecured creditors (and merely share in the debtor's projected disposable income, if any, for a period of 3 to 5 years).   Secured creditors still have ways of ensuring that they retain their lien (under 11 U.S.C. 1111(b)), but there are ways of stretching out payments over decades, with no interest, when creditors choose this tactic.

       5.   Post-Petition Income And Assets Will Be Subject To Creditor Claims Unless All Classes Vote To Confirm Case

            Under Subchapter V all cases are divided into two different types:  Cases where all impaired classes of creditors vote to accept the debtor's plan of reorganization, and cases where they do not.  In the former, post-petition income never becomes property of the bankruptcy estate, the debtor receives a discharge upon confirmation of its Chapter 11 plan, and property revests in the debtor upon confirmation of its plan.  These are significant advantages which give debtors a strong incentive to try to obtain creditor consent to plan confirmation.      

            If all impaired classes do not vote to accept the plan, things are quite different.  All post-petition income (through the completion of all plan payments) remains property of the bankruptcy estate.  This includes not only income, but inheritances and windfalls from any other source, including life insurance payouts.  11 U.S.C. §1186.  Further, the discharge is delayed at least three years.  11 U.S.C. §1192.    Finally, the plan must provide “appropriate remedies, which may include the liquidation of nonexempt assets, to protect the holders of claims or interests in the event that the payments are not made.”  1191(c)(3)(B). 

       6.  Chapter 11 Trustees Will Be Motivated To Assist Debtors In Confirming Their Plan of Reorganization

            A Chapter 11 trustee is appointed in every Subchapter V case.  However, Chapter 11 trustee compensation in Subchapter V is markedly different from typical Chapter 11 Trustee compensation otherwise.  Ordinarily, Chapter 11 trustees are paid from the distribution of assets to creditors - - which tends to occur when large assets are sold.  However, in Subchapter V Trustees receive compensation on a percentage-of-distribution basis made by the debtor, similar to a Chapter 13 trustee.  Like Chapter 13, the goal of a Trustee will be to confirm plans and get creditors paid.  This contrasts sharply with current cases where the goal is to sell expensive assets.  This is very good news for debtors because the Chapter 11 Trustee will likely be their ally in confirming a plan. 

      7.  No Creditors Committees and No Disclosure Statement Required

            Unlike other Chapter 11 cases, creditors' committees will not ordinarily be formed (absent Court Order allowing it) and disclosure statements are not automatically required.  This will save significant funds and reduce professional fees in a case.  It is also critical to note that unlike current practice, administrative claims (including attorney fees for the Debtor) can be paid over time rather than in full upon confirmation.  11 U.S.C. §1191(e).

      8.   Conclusion

            Subchapter V is an earthquake in bankruptcy practice for small and medium-size businesses throughout the United States.  There are certain minimums, however, which debtors still cannot avoid.  The best-interests-of-creditors test, which requires that creditors receive what they would have received in a Chapter 7 case, still applies.  Especially now when many people have significant equity in their homes, this will require significant payments in some Subchapter V cases.  Small business debtors with little equity will not face this obstacle, and may find that plans paying virtually nothing to unsecured creditors are easily confirmable.