Howard C. Meyer
Meyers Law, PLLC
Phoenix, Arizona 2810
North Third Street
Tel: (602) 900-5001
Cell: (602) 292-3151
Business Bankruptcy Specialist, American Board of Certification
Creditors’ Rights Specialist, American Board of Certification
Certified Bankruptcy Specialist, State Bar of Arizona Board of Legal Specialization Member, State Bars of Arizona and New Mexico
If your business has $7,500,000.00 or less in debt, it is a candidate for a Chapter 11 filing under Subchapter V of the Small Business Reorganization Act. The $7,500,000.00 debt ceiling excludes debts that are contingent (e.g., a claim based on a guarantee of another’s debt that is not in default) or unliquidated (e.g., a filed tort lawsuit that is pending but not adjudicated). Businesses that are primarily single asset real estate entities are excluded from Subchapter V eligibility. Section 1182(1)(A).
The longer your business’s “burn rate” (negative cashflow) continues to destroy your working capital and ability to maintain inventory or operations, the less likely it is that your business will survive. Waiting to file a Chapter 11 case until there is no more liquidity left in your business means that you are waiting until your business will be in a full-blown death spiral. By that time, it may be too late to be able to save the business by filing for Chapter 11.
Many small businesses in the post-Covid 19 world we live in are headed to closure unless a radical solution can be found and found fast. That radical solution is a Subchapter V small business reorganization under Chapter 11 of the Bankruptcy Code.
The time to file a Chapter 11 is when there is still money in the system. This is the lesson that too many businesses learn after it is too late, and the tap has run too dry for the business to be rescued.
A Chapter 11 filing under the Small Business Reorganization Act which went into effect in February, 2020, offers a more cost-effective reorganization path for smaller businesses than traditional Chapter 11 reorganizations. It provides an enhanced ability on the part of the debtor to confirm a plan because it curtails some of the historical obstacles that creditors could exploit to keep smaller closely held debtors from getting over the reorganization goal line. Upon filing, an estate is created which includes all of the non-exempt assets of the debtor wherever located. The estate continues in existence until plan confirmation.
Under the original Subchapter V $2,725,625.00 was the debt ceiling cap for Subchapter V treatment. Under the Coronavirus Aid, Relief and Economic Security (CARES) Act enacted on
March 27, 2020, the debt ceiling cap was increased to $7,500,000.00 for the next year. This is for now a time limited “bump up” in the debt ceiling but one which is subject to possible extension.
The underlying concept of Subchapter V is a streamlined and fast track abridged version of Chapter 11 for small business debtors. Subchapter V debtors are required to file a plan not later than 90 days after entering bankruptcy, unless the need for the extension is caused by circumstances “for which the debtor should not justly be held accountable.” Section 1189(b). Only a debtor may file a chapter 11 plan in a case under Subchapter V so that the expense and uncertainty of dealing with competing creditor plans is eliminated in small business reorganizations.
Subchapter V permits the business to be run under bankruptcy court protection by its owner as a debtor in possession with the general rights normally held by a bankruptcy trustee including the express right to operate the business of the debtor without any interference by a bankruptcy trustee. Section 1184. Although there is a Subchapter V trustee appointed in every case, his or her main role is to serve as an advisor and resource person for debtors. The trustee’s mandate is to assist the debtor and its counsel in any way practicable. This includes mediating disputes with creditors in order to make it more likely for the case to proceed to plan confirmation. The Subchapter V trustee is compensated out of the distributions made to creditors at the rate of five percent (5%) so that the trustee has a vested interest in a debtor’s success in confirming a plan.
Subchapter V allows a debtor to spread its debt repayments out over three (3) to five (5) years during which time the debtor must devote its projected disposable income to the plan (discussed infra). This debt extension can often be joined with a debt composition which allows the amounts creditors are to be repaid on a “haircut basis” at less than the full-face amount of the creditors’ claims. While extended discussion of plan details are beyond the scope of this general discussion, almost all chapter 11 reorganization plans involve the use of debt extension and/or debt composition concepts.
In contrast to ordinary chapter 11 cases where post-petition administrative expense claims have to be paid on a plan’s effective date in full and in cash, a small business debtor in Subchapter V may stretch out payment of administrative expense claims over the term of the plan. Section 1191(e). This makes plan confirmation under Subchapter V easier for cash strapped debtors.
In keeping with the spirit of simplification and cost reduction, Section 1181(d) of Subchapter V provides that a committee of creditors will not ordinarily be appointed unless ordered by the Bankruptcy Court for cause, thereby eliminating in most cases the costs of a creditors’ committee and its professionals who are paid for by the debtor even though the professionals work for the creditors’ committee and are not subject to direction by the debtor.
This helps make small business reorganizations under Subchapter V much more manageable as creditors’ committees and their professionals can become adversaries to not only reorganization debtors but also to the equity owners of those debtors. Subchapter V debtors are excused from the obligation imposed on other chapter 11 debtors to pay quarterly fees to the United States Trustee on a sliding scale which maxes out at one percent (1 %) of revenues of $250,000 or more per quarter. This is another aid for cash strapped debtors. One of the biggest benefits of Subchapter V is that it eliminates the “new value rule” in small business reorganizations which normally required the owners to provide “new value” if they wanted to retain their equity interest in the business. This meant that owners had to pay in new
money to buy back their equity interest in the debtor from its creditors in addition to making payments to the creditors over the course of time. Many of the tools that creditors used to derail small closely held businesses from reorganizing focused in on fights about the new value rule and whether the equity interest had to be put up to auction which was nonsensical in the context of sole proprietorships or small closely held corporations and limited liability companies.
Another big benefit of Subchapter V is that a debtor can confirm a plan even without voting acceptance by creditors. In a regular Chapter 11 case, creditor voting is required. In a Subchapter V case, a debtor can confirm a plan without acceptance by creditors provided it (1) meets the “best interests test; (2) does not “discriminate unfairly”; and (3) is “fair and equitable.”
The voting requirements of non-Subchapter V reorganizations impose a great deal of complexity, expense and creditor veto power that is eliminated in Subchapter V small business reorganization cases. Simply stated, the “best interests test” is that creditors must receive as much under the plan as they would in a chapter 7 liquidating case.
The “best interest test” is measured by what would be received from a hypothetical sale of all the assets by a chapter 7 trustee. Under new Section 1191 of the Bankruptcy Code, a plan is generally “fair and equitable” if it pays creditors the debtor’s “disposable income” for a period of three (3) to five (5) years. This concept of “disposable income” includes income that is reasonably necessary to be expended “for the payment of expenditures necessary for the continuation, preservation, or operation of the business of the debtor.” Section 1191(d)(2).
Reasonably necessary expenditures include compensation for the owner(s)/manager(s) of the business. Secured creditors are persons or entities who have liens in real property or personal property owned by the debtor. Secured creditors retain their rights to have their collateral “adequately protected” against diminution in value or be granted relief from the Bankruptcy Code’s automatic stay to realize on their collateral pursuant to Section 362(d).
Adequate protection payments are keyed not to the amount of pre-bankruptcy contracts but rather to true economic depreciation post-petition for rolling stock (vehicles, trucks and equipment) or collateral base requirements (replenishing the level of inventory or raw materials post-petition as collateral is sold or incorporated into manufactured goods) and providing the secured creditor with a post-petition replacement lien. Under Section 506, the claims of secured creditors are normally secured up to the fair market value of the collateral and “undersecured” to the extent that their claims as of the filing date exceed the fair market value of the collateral.
Thus, if a creditor has a purchase money security interest in a truck with a fair market value of $10,000.00 owned by the business with a $15,000.00 balance due and owing at the time of the case filing, the creditor has a secured claim for $10,000.00 for its lien on the truck and an unsecured claim for $5,0000.00 to the extent it is undersecured. The same concept applies to any other type of collateral including real estate.
Because debtor owned real estate is sometimes perceived as an asset whose starting value may escalate or appreciate over the three (3) to five (5) year life of the plan, secured creditors with a lien on debtor owned real estate are entitled under some circumstances to make an election under Section 1111(b)(2). This avoids having their claim bifurcated into secured and unsecured portions. This election enables them to recover more in the event of a future sale or refinancing of the real property collateral security if they are prepared to accept what is usually a smaller stream of payments during the life of the plan because of the election.
The plan process is greatly streamlined in Subchapter V. No disclosure statement is required. The disclosure statement phase of a Chapter 11 was normally very costly and burdensome for small business debtors. There are four main advantages offered to a business under Subchapter V that are not available outside of bankruptcy.
The first is the automatic stay of Section 362(a) of the Bankruptcy Code which stops creditors from being able to pursue their ordinary collection rights against your business. Collection demands, garnishments of bank accounts, lawsuits, repossessions, evictions all must stop automatically once the Chapter 11 is filed.
Anybody who does not honor the automatic stay can and will be sanctioned by the Bankruptcy Court under the force of federal law. The automatic stay is essentially an injunction which issues automatically upon the filing of the case without the burden or expense of a bond requirement as would be the case with a nonbankruptcy court injunction. The second main advantage offered to a business under Subchapter V is the ability to reject unneeded executory contracts in the form of such things as property leases, equipment leases and service contracts so as to bring the monthly “nut” down for the business so it can survive.
For ease of illustration, there is the executory contracts category of real property leases for shopping center spaces, warehouses, plants or offices as an example. An executory contract is essentially a contract between the debtor and a non-debtor for which both sides of the contract owe one another reciprocal continuing and ongoing duties of performance. By way of illustration, the reason that a debtor’s real property shopping center lease is deemed an “executory” contract is because the landlord has a continuing obligation over the life of the lease to provide use of the premises to the debtor while at the same time the debtor has a continuing obligation to make its monthly rent payments, to keep the premises insured and to perform other ongoing obligations over the life of the lease.
By way of contrast, if a debtor buys its premises from a former landlord and merely owes the landlord a promissory note representing the balance of the purchase secured by a lien on the premises, this debtor-creditor relationship is “non-executory.” The former landlord owes no continuing duty of reciprocal performance to the debtor. The landlord is merely a creditor and no executory contract is implicated by the relationship of the parties.
For a debtor engaged in a business with multiple locations, the ability to get out of locations that are unprofitable is central to its financial survival. A debtor under Chapter 11 is given the ability to “reject” the remaining portions of these types of real property leases with certainty and closure. If a business files a Chapter 11, a motion to reject executory lease contracts because they are burdensome can be ready to file on the first day of the case. The motion and a notice are sent out and landlords have 21 days plus a short mailing period to object. There is very little landlords can effectively do or say in terms of objecting to the rejection.
The rejection will relate back to the filing date thus reducing the cash drain with regard to such leases. Section 502(b)(6) caps a landlord’s claim in bankruptcy for damages resulting from the termination of a real property lease. Under Section 502(b)(6), a landlord-creditor is entitled to a damage claim from a rejected lease based upon the following simple formula: the greater of one lease year or fifteen percent (15%), not to exceed three years, of the remaining lease term. The cap operates from the earlier of (a) the petition filing date; (b) the date on which the lessor repossessed the leased property; or (c) the date on which the lessee surrenders the leased property. The landlord
also retains a claim for any unpaid rent due under such lease prior to the earlier of these three (3) alternative dates. The landlord’s claims from a lease rejection are paid under the plan on a three to five-year term. This cap on claims and this “stretch out” of payment is very different than the kinds of outcomes businesses have with their landlords in a non-bankruptcy setting where leases tend to be converted into large court judgments and subsequent garnishments of business bank accounts.
Just as executory contract can be rejected, they can also be “assumed” which is a term of art which means that they are reaffirmed. To assume executory contracts under Section 365(b), small business debtors must cure defaults within a reasonable time and, where required, provide adequate assurance of future performance. Sometimes the curing of defaults can be stretched over a period of time to again aid cash strapped debtors. The expectation of most people is that a reorganization permits the modification of any and all of the debtor’s obligations. This is generally true except for executory contracts which are assumed.
A contract or an unexpired lease must be assumed subject to its terms and conditions. Unless the non-debtor party consents to modification, a debtor cannot accept part of an executory contract and reject other parts of the same executory contract. If a debtor wishes to have the benefit of its unexpired executory contract, it must also accept the burdens of it. As an example of this principle, if a debtor has a lease of 5000 square feet of shopping space, the debtor cannot assume the lease with regard to 3500 square feet and reject it as to the other 1500 square feet.
Notwithstanding this “all or nothing” aspect of executory contract assumptions, there is much that can be negotiated with regard to modifying assumed executory contracts. Before leaving the area of executory contracts, it is appropriate to briefly discuss the difference between true leases of personal property and capital leases or “financing leases” of personal property. Section 365 only applies to “true” or “bona fide” leases which are executory contacts. Section 365 does not apply to financing leases which are generally characterized as secured transactions giving rise to a secured creditor relationship and the applicability of the Section 506 concepts of “secured” and “undersecured” and the right to modify terms. In a capital lease or a financing lease,
there is a security arrangement by which the debtor as the purchaser of equipment arranges for title to be transferred to an entity from whom the debtor purchaser borrows money to affect the purchase at a rental rate that eventually will cover the amount of the loan at the end of which title will be transferred to the debtor purchaser without regard for the true economic value of the leased equipment. The one-dollar ($1.00) lease end purchase option is a common hallmark of financing leases. The third main advantage of Subchapter V is that once a plan is confirmed, Section 1227(b) provides that ordinarily confirmation of the plan vests all property of the estate back in the debtor.
Creditors are required to abide by the treatment accorded to them by the plan once the plan is confirmed by order of the bankruptcy court. The fourth main advantage is that the business owners and management of the debtor are relieved of spending a lot of their time dealing with creditors instead of managing and growing the business. Chapter 11 clears the decks of past financial problems and permits the owners and managers of the business to focus on the present and future instead of the past.
There is also the matter of first day orders. These first day orders address a variety of issues with regard to the continued operation of the business and the use of cash collateral or other collateral of a debtor’s secured creditors. Some secured creditors have a security interest in the cash flow from operations or a security interest in collateral in the form of depreciating equipment, etc.
Their consent or a court order is required as a condition to the debtor’s right to use such collateral after the case filing. Some of the first day orders are typically directed at paying the prepetition portion of payroll and benefits despite the general precept that prepetition unsecured obligations are not supposed to be paid after the filing. First day orders are normally routine and worked out in advance with the affected creditors by bankruptcy counsel. Finally, there is the matter of discharge. Upon the completion of all plan payments, Section 1192 provides that a debtor shall be granted a discharge of any debt that arose before confirmation of the plan and claims arising from the rejection of executory contracts and other specified claims.
The concept of discharge is a release of a debtor’s liability for the debt. Essentially it is an injunction against attempts to collect the debt as a liability of the debtor to the extent the debt exceeds what is provided to a creditor under a confirmed Subchapter V plan of reorganization.