Is Subchapter V Bankruptcy a Good Option for Your Small Business?
There has been quite a bit of “buzz” recently among financial professionals for small businesses about a new “subchapter V” in the bankruptcy law. It has been touted as a less costly and more streamlined method to reorganize business debts than under a conventional chapter 11 case. In this article, we’ll take a brief look at how the subchapter-V process works and whether it might make a small-business reorganization more feasible and less expensive than it was before “Sub V” was enacted.
The Big Picture
To understand how subchapter V works, it is necessary first to understand how it fits within chapter 11, which governs relief that is afforded to individuals and business entities who seek to retain assets and restructure debt. It is also helpful to understand how chapter 11 fits within the Bankruptcy Code itself, which consists of a number of different “chapters.”
- Chapter 7 Liquidation.
A domestic business entity (a corporation, limited liability company, or limited partnership), generally has two avenues for relief under the Bankruptcy Code: under chapter 7 or chapter 11.[1] If the business is no longer viable (it is losing money on an ongoing basis and does not have the means to turn things around) and therefore needs to “close the doors,” a chapter 7 bankruptcy case may be the most logical way to wind up the business so that the debtor entity can be dissolved (terminated).
When the entity files a chapter 7 petition, it should already have ceased operating and must do its best to gather up and safeguard its physical assets. As soon as the petition is filed, the automatic stay of bankruptcy will serve to stop all creditor actions, such as lawsuits and levies of property. A bankruptcy trustee is appointed, whose primary job is to investigate and dispose of any assets of value that might be held by the debtor. For example, if a debtor had a retail sales operation, the trustee would determine if any leftover inventory or store equipment could be auctioned, so that the proceeds (after payment of any debt secured by such property and costs of sale) could be ultimately be disbursed to creditors. Ideally, the trustee sells essentially all assets of value and then disburses the proceeds to creditors. When the process is complete and tax returns filed, the owners can have the debtor entity dissolved under state law, terminating its existence. The owners should realize, however, that in addition to selling assets and paying debts of the debtor entity, the chapter 7 trustee is also to investigate and pursue the avoidance of pre-bankruptcy transactions that may have occurred but which did not have reasonable benefit to the debtor.
- Chapter 11 Reorganization.
When the business is experiencing severe financial straits, such as being on the losing end of a large judgment or suffering from a cash-flow crunch that might be turned around with adjustments to its business model, chapter 11 has historically been the sole option under the Bankruptcy Code to preserve the ongoing business and reorganize the debtor’s finances, typically without the involvement of any trustee.
All chapter 11 cases, including Sub V cases, revolve around the approval of a Plan of Reorganization (the “Plan”), which represents a comprehensive “re-write” of the debtor entity’s obligations to its creditors and parties with which it holds ongoing contracts. In the conventional chapter 11 case, a Plan is typically proposed by the debtor, but after a certain amount of time passes, creditors or other parties may propose a Plan as well, whether or not the debtor likes it. Holders of so-called “impaired” claims vote to accept or reject proposed Plans, and cases in which more than one Plan has been proposed become procedurally complex in no time, adding to the length and expense of the case. By contrast, in Sub V cases only the debtor may propose a Plan, which avoids the potential problems caused by multiple Plans.
A bankruptcy trustee is not typically appointed in a conventional chapter 11 case. The debtor entity files a voluntary chapter 11 petition to obtain the benefit of the automatic stay, stopping creditor efforts to collect debts, but continues to maintain control over the entity’s assets and to operate its business, as a fiduciary for the benefit of its creditors.
Until recently, chapter 11 was a “one size fits all” proposition, providing a single procedure under the Bankruptcy Code for any large or small corporate entity (except railroads, which were made subject to unique procedures under subchapter IV of chapter 11), to obtain a comprehensive restructuring of debt. As such, businesses on “Main Street” had to resort to the very same procedures as businesses on “Wall Street.” A mom-and-pop organization was subject to the same complex process of reorganization as a multinational U.S. corporation like General Motors.
While chapter 11 is a powerful tool to reorganize, even over the objections of creditors, the typical chapter 11 case is a complex and therefore costly process. Over the course of the case, extensive financial disclosure and reporting is required, and there are various restrictions on the uses of money and/or the need to obtain prior court approval. The chapter 11 plan, typically proposed by the debtor, must meet numerous legal standards and must be voted on by creditors before it can be approved by the court, where at least one class of “impaired” claim holders must vote to approve the plan. And, before the proposed plan can even be distributed to creditors for review and voting, the court must approve a Disclosure Statement with a detailed account of facts deemed necessary for creditors to make an informed choice as to whether or not to vote in favor of the Plan.
Since the last overhaul of the bankruptcy laws in 1978, Congress made some effort to modify the process to suit small businesses, but such effort was limited and in many ways was directed merely to forcing the smaller debtor to move the case faster, without significant reduction in the procedural burdens of the case. In 2019, however, Congress enacted an entirely new subchapter of chapter 11, which was titled “subchapter V” and became effective in 2020. Congress intended subchapter V to allow qualifying debtors to elect a streamlined process under which a small business may be reorganized and its financial affairs rehabilitated.
The Subchapter V Option
As noted above, Sub V has been touted as a significant improvement in making the chapter 11 better process suited to the “small-business debtor.” Next, we’ll explore the differences and the pros and cons of the Sub V process.
- Who Qualifies for Sub V?
To elect a Sub V case, the chapter 11 debtor must meet certain qualifications. First, the debtor must be engaged in “commercial or business activities,” and have aggregate debts that do not exceed a certain amount (the “debt limit,” discussed below). More than half of its debt must be business related. This standard is easy to meet where the debtor is not an individual, since essentially all debt is typically related to the debtor’s business (while by contrast individuals may have household or consumer debt, in addition to business debt).
The debtor is ineligible for Sub V if (i) its primary activity is to own a single piece of real estate that among other qualifications generates substantially all revenues of the debtor (which would require a so-called “single-asset real estate” case, instead); (ii) if it is a corporation subject to reporting under the Securities Exchange Act of 1934 or if it is an affiliate of an issuer under such Act, or (iii) it is a member of a group of affiliated debtors with aggregate debts in excess of the debt limit, discussed below.
Finally, the debtor must comply with the “debt limit,” where the aggregate amount of debt that is not contingent or unliquidated, and is not owed to “insiders,”[2] cannot exceed $7,500,000.00. The amount of the debt limit was significantly increased, from $2,725,625, pursuant to Covid-related legislation that expired but where Congress later reinstated the $7,500,000 limit.
- Major Differences Between Sub V and Conventional Chapter 11 Cases.
What does it mean, in practical terms, to proceed under subchapter V? For the most part, it means that the case will be somewhat less complex, but also that the debtor must move towards confirmation (approval) of its proposed Plan of Reorganization more quickly than otherwise. As explained below, that process is streamlined to some extent, but other features of chapter 11 are not.
The most significant procedural change in Sub V cases is the elimination of the Disclosure Statement. The Sub V debtor need not draft, file, or gain approval of a Disclosure Statement before circulating a proposed Plan of Reorganization. This eliminates what is sometimes a protracted process in the conventional chapter 11 case, saving time and legal expense.
But perhaps more important, the legal standards for confirmation of the Plan are less onerous for the Sub V debtor compared to the conventional chapter 11 debtor. While a complete discussion of the differences are beyond the scope of this article, perhaps the most important difference involves elimination of the need to obtain approval of at least one class of impaired creditors. The votes of creditors are counted in according to the dollar amount of the claim. A vote of a creditor whose claim is $10,000 is worth ten times the vote of a creditor whose claim is $1,000. This makes it possible in a non-Sub V case for a creditor holding a large claim to “control” the class in which its claim is placed, by withholding an affirmative vote. This can render the debtor a “hostage” if it becomes necessary that such class approve in order to accomplish the single accepting class. When a debtor has to deal with a creditor that can single-handedly block confirmation, negotiations and proceedings can become protracted, making the case more expensive and risky than otherwise.
In addition, the so-called “absolute priority” rule is not applied in the Sub V Plan confirmation process in the same way as in a conventional chapter 11 case. At the risk of oversimplifying, it can be said that the rule, which typically means that the Plan must propose to pay unsecured creditors in full with interest (if the owners of the debtor entity are to retain an ownership interest after confirmation), is changed to require instead that all of the debtor’s net revenue (“projected disposable income”) for a three- to five-year period be disbursed to claim holders. This is the so-called “best efforts” test under Sub V, which is similar to an analogous test for confirmation of plans in chapter 12 (family farmers) and chapter 13 (individuals with regular income).
As noted above, in a conventional chapter 11 case, no trustee is appointed at the outset of the case. If, however, cause is found to do so in a conventional case, a trustee may be appointed, taking the debtor out of possession of the assets and out of control of the business (and making this event a disaster for those who wish to control the course of the debtor’s reorganization).
Paradoxically, in a Sub-V case, a trustee is appointed right at the outset of the case, but the Sub V trustee has fewer powers and responsibilities than in a non-Sub V case. The Sub V trustee does not take possession and does not run the business. Instead the trustee’s major role is to monitor the case and to facilitate the confirmation of a so-called consensual Plan, where impaired classes support confirmation. The trustee may also, depending on how the confirmation process plays out, be involved in the distribution of funds to creditors under the confirmed Plan.
The Plan must generally provide that the Sub V trustee will be paid for his or her work, typically at customary hourly professional rates after court approval, but this is usually a better alternative for the debtor than the quarterly fees that the debtor must pay to the United States Trustee (the federal agency that supervises bankruptcy cases) in a conventional chapter 11 case. At this time, such fees are based primarily on a sliding-scale percentage of the amount of funds disbursed each quarter during the case, until it is closed, dismissed, or converted to another chapter. Where a debtor pays large amounts of expenses during a quarter, or where it sells assets of significant value where it must pay secured claims from escrow, the quarterly fees can become prohibitive in amount. It can thus be a significant advantage of the Sub V case that the quarterly fees do not apply.
Finally, in a Sub V case, the debtor is the only party who may propose a Plan. The debtor must do so, however, within 90 days of the filing of the bankruptcy petition, which is a relatively short period of time should the case have unusual complexities or legal issues needing resolution before a viable Plan can be proposed. The court, however, has authority on request to extend the period, so long as the requested extension is based on circumstances “for which the debtor should not justly be held accountable.”
Is Sub V a Good Choice?
As noted above, conventional chapter 11 cases are often expensive for the debtor to maintain. The amount spent on attorneys’ fees is generally related to the complexity of the case and the extent to which creditors act litigiously. Cases with few assets and creditors, or without significant business operations such as retail stores, tend to be less expensive. Multiple-asset cases with many creditors tend to be more expensive, as do those where animosity from a pre-bankruptcy dispute, particularly among former business associates, “carries over” into the chapter 11 case in the form of unanticipated, unwelcome litigation in the Bankruptcy Court. In addition, the longer the case is open, generally the more expensive it will become. Much like a creditor’s failure to moderate its behavior once a chapter 11 case is initiated, a debtor’s failure to cooperate with counsel in providing assistance and information for the case will also result in a greater amount of fees and costs, and will substantially reduce chances for success.
While Sub V does reduce the procedural burdens of a chapter 11 to an extent, Sub V does not moderate any complexity that may exist or eliminate any animosity borne by creditors towards the debtor. While procedural burdens are reduced, the Sub-V case still has significant reporting and disclosure requirements that every debtor must observe. But Sub V’s less stringent standards for Plan confirmation is a significant benefit to debtors in cases where there otherwise insurmountable obstacles to confirmation might exist. As such, it has been this attorney’s experience that the Sub-V case is a welcome “tool in the business debtor’s toolbox,” so long as the debtor meets the qualifications for a Sub-V case. But while the parties can typically expect that the Sub-V process will reduce the costs of the Plan-confirmation process, and help make confirmation more likely, it does not eliminate the need to plan carefully, move quickly, and comply with the significant disclosure and reporting requirements inherent in all chapter 11 cases.
Unfortunately, whether Sub V saves a significant amount of money on legal expenses isn’t often known until the case runs its course. While it is always best to avoid bankruptcy if at all possible by working out deals with creditors instead, should bankruptcy become the only option, subchapter V of chapter 11 is generally a good option if the debtor meets the qualifications for filing a such a case.
[1]. This discussion does not cover businesses that are operated as proprietorships, where an individual owns the business assets and operates the business. While an individual may seek relief under chapter 7 or chapter 11 (and also chapter 13) of the Bankruptcy Code, bankruptcy cases of individuals involve numerous additional issues that will influence the choice of which chapter to pursue, and such issues are beyond the scope of this article. Also, this article does not address the bankruptcy case initiated by a general partnership, where, depending on circumstances, the individual partners’ assets may become subject to the bankruptcy process.
[2]. In the context of this Article, a debtor’s “insiders” will usually consist of individuals or entities who own, manage, or control the debtor entity, and the family of such individuals or entities, or entities that have common ownership and management with the debtor entity.
© 2022, Anthony Asebedo
Attorney at Law