Business Law

Small Business Reorganization Act of 2019

FIC ebulletin prepared by Mike Slattery, Tom Kelch and Barry Glaser, Bankruptcy Practice Group at Lamb & Kawakami LLP

On February 19, a new bankruptcy law became effective. The new law makes it easier for borrowers to change the terms of secured loans. Keep reading. The end of this article summarizes those changes.

It’s ironic, but it costs a lot of money for a business to go through a Chapter 11 reorganization.

There is a lot of paperwork and court appearances, so the business will need an experienced debtor’s counsel. There is a case filing fee of $1,167 plus and administrative fee of $500.

The Office of the United States Trustee, which oversees the administration of bankruptcy cases, will charge a quarterly fee, based on the amount of disbursements during the quarter. The fee ranges from a minimum of $325 (disbursements under $15,000) to the lesser of 1% of disbursements or $250,000 (disbursements of $1 million or more). 28 U.S.C. §1930(a)(6). The United States Trustee will appoint an official committee of unsecured creditors, Bankruptcy Code §1102 (all references are to the Bankruptcy Code unless otherwise indicated), which will be able to hire its own lawyers and accountants, §1103(b), who will be paid out of the company’s assets. The Chapter 11 debtor has to prepare two big documents—a plan of reorganization which explains how creditors, grouped into classes, will be paid, and a “disclosure statement” which gives some history of what led to the bankruptcy, explains the terms of the plan and how the debtor will implement it, and explains how the debtor will operate its business after the plan is confirmed.

Chapter 13 is a simpler reorganization alternative. But is only available to individuals with unsecured debts less than $419,275 and secured debts of less than $1,257,850. §109(e). So unless the business is run by its owner as a sole proprietor and has relatively little debt, Chapter 13 is not available. 

Congress has lessened the burden a little with a new Small Business Reorganization Act (the “Act”). It is codified as new Subchapter V of Chapter 11, §§1181-1195, and became effective on February 19, 2020.  A business may elect to reorganize under this new law if: (a) it has noncontingent, liquidated debts, secured plus unsecured, of less than $2,725,625; “(excluding debts owed to 1 or more affiliates or insiders) and (b) at least 50% of that debt is from the debtor’s business activities. §101(51D(A)).

Important update: The CARES Act, which was passed on March 25, 2020, increased the eligibility threshold to $7,500,000 for cases filed in the year following its enactment. CARES Act §1113, Bankruptcy Code §1182.

A case under the Act is less costly for the debtor because there is no official creditors committee unless the court specifically orders otherwise, no requirement of a disclosure statement before creditor voting, and no United States Trustee fees. And there are some new rules which make it easier to confirm a plan over creditors’ objections. For example:

  • No “absolute priority rule:” In a regular Chapter 11, §1129(b), the so called “absolute priority rule,” means that if a class of creditors rejects the plan, the plan cannot be confirmed if a subordinate class receives anything of value under the plan. The practical application is the shareholders cannot retain their ownership interests if the unsecured creditors are not paid in full and object to the plan. There is a court-made exception to that rule if the shareholders contribute “new value” to retain their interests. These rules do not apply in a Small Business Reorganization  Instead, the test for confirmation is that the debtor will use all disposable income to make payments under the plan or distribute property with a value not less than all projected disposable income for the term of the plan. §1191(c). The term of a plan is 3 years; the court may extend that term to up to 5 years. §1191(c).  
  • Administrative expenses can be paid over time. “Administrative expenses” are debts incurred after the bankruptcy case is filed. They have the highest payment priority among unsecured claims. In a regular Chapter 11,  they must be paid upon plan confirmation. §1129(a)(9)(A). In a Small Business Reorganization, they may be paid over the term of the plan. §1191(e).
  • No need for at least one class of creditors to accept the plan. In a regular Chapter 11 case, at least one class of creditors with impaired rights must vote to accept the plan. §1129(a)(10). This rule does not apply in a Small Business Reorganization. §1181(a).
  • The plan can change the terms of a mortgage secured by the debtor’s principal residence. Neither a Chapter 13 plan nor a Chapter 11 plan may change the terms of loan secured by a mortgage against the debtor’s principal residence unless the loan matures before plan payments end. §§1123(b)(5) and 1322(b)(2). This rule does not apply in a Small Business Reorganization if (a) the loan was not used primarily to acquire the residence; and (b) the proceeds were used primarily in the operation of the business. §1190(3).
  • The debtor does not get a discharge until payments are completed under the plan (this differs from ordinary chapter 11 cases where the discharge occurs on confirmation of a plan). Furthermore, if the debtor fails to perform the debtor’s obligations under any confirmed plan, a new § 1185 (a) permits the court to remove the debtor as debtor in possession. If postconfirmation removal occurs, the U.S. Trustee may reappoint the trustee. New § 1183 (c).

There don’t seem to be a lot of downsides, but they are:

  • Need to act fast: The debtor must file a reorganization plan with 90 days unless the court extends that deadline based on circumstances which are not the debtor’s fault.§1189. If the debtor does not elect to use the provisions of the Act, the deadlines for a small business case are 300 days from filing the case and confirmation within 45 days later. §§1121(e) and 1129(e).
  • Standing Trustee: The case is supervised by a standing trustee to oversee the case, though the debtor continues to run its business.§1184. Section 1183(b) lists the trustee’s duties which include, “facilitate the development of a consensual plan of reorganization,” “ensure that the debtor commences making timely payments required by a plan …,” and filing required lists and statements if the debtor fails to do so.  
  • More “property of the estate:” In a regular Chapter 11 case, the “property of the estate” which must be used to pay the creditors is what the debtor owned on the filing date (plus the proceeds of those assets). §541. In a Small Business Reorganization, that property includes assets and earnings from services that the debtor acquires after the case is filed.  §1186.

CHANGES IMPORTANT TO LENDERS

  • Reduced ability to veto a plan. If the amount of a secured claim exceeds the value of the lender’s collateral, the lender will have two claims: (a) a secured claim in the amount of the value of the collateral; and (b) an unsecured claim for any excess. This rule often gives the lender a large enough unsecured claim that it can control how the class of unsecured creditors votes on the plan. Coupled with the rule in regular Chapter cases that at least one impaired class of claims vote to accept the plan, a significantly “undersecured” creditor can control whether the plan can be confirmed .
  • Modification of loans secured by debtor’s principal residence: The owner of a small business often gives its lender a lien on his or her home to secure a loan to his or her business. In a case under the Act, the debtor can modify the terms of that loan so long as it was not used (primarily) to purchase the home and the proceeds were used (primarily) to operate the business.

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