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Notable Developments on The Small Business Reorganization Act of 2019

December 15, 2020

By
Lea Pauley Goff
Spencer K. Gray

Attorneys, Stoll Keenon Ogden PLLC
(502) 333-6000
lea.goff@skofirm.com
spencer.gray@skofirm.com

The Small Business Reorganization Act of 2019 (“SBRA”) may provide a simpler and cheaper avenue to reorganize under the Bankruptcy Code. The SBRA, which is referred to as subchapter V of chapter 11, is intended to mitigate obstacles of traditional Chapter 11 reorganizations including high administrative costs, difficult confirmation requirements, and significant creditor influence over the confirmation process.  It became effective February 19, 2020 and is available to most small businesses who meet the debt caps discussed below.

Th Act’s purpose is explained by House Committee on the Judiciary Report No. 116-54, which states that, “[s]mall business chapter 11 cases continue to encounter difficulty in successfully reorganizing,” and that the SBRA, “allows [small business] debtors to file for bankruptcy in a timely, cost-effective manner, and hopefully allows them to remain in business,” which “not only benefits the owners but employees, suppliers, customers, and others who rely on that business.”

Court Decisions Recognize that SBRA’s Purpose is to Make Small Business Reorganization Cheaper And Easier

In In re Penland Heating & Air Conditioning, Inc., No. 20-01795, 2020 LEXIS Bankr. 1550 (Bankr. E.D.N.C. June 11, 2020), a North Carolina bankruptcy court examined and recognized that SBRA’s purpose is to make small business reorganization cheaper and easier when it questioned the role of expensive and zealous counsel in such cases. The court held that subchapter V trustees (automatically appointed in SBRA cases) are not permitted to hire counsel as a matter of course and should carefully consider whether to do so because they will not be compensated if the hired counsel is overzealous or undertakes unnecessary or duplicative services. The court reasoned that “authorizing a Subchapter V trustee to employ professionals, including oneself as counsel, routinely and without specific justification or purpose is contrary to the intent and purpose of the SBRA,” which is to streamline the reorganization process for small businesses.

Recent Court Decisions Highlight Important Differences Between Subchapter V And Traditional Chapter 11 Reorganization

Five of the most important distinctions between reorganization under the new subchapter V and a traditional chapter 11 reorganization are that the SBRA “(1) modifies confirmation requirements; (2) provides for participation of a trustee . . . while the debtor remains in possession of assets and operates the business as a debtor in possession; (3) changes several administrative and procedural rules; . . . (4) alters the rules for the debtor’s discharge and the definition of property of the estate with regard to property an individual debtor acquires postpetition and postpetition earnings;” and (5) permits only the debtor to file a plan or plan modification. Paul W. Bonapfel, A Guide to the Small Business Reorganization Act of 2019, 93 Am. Bankr. L.J. 571, 576 (2019).

Important among these distinctions, a court may confirm a plan under subchapter V even if all creditor classes reject it and may do so without adhering to the “absolute priority rule,” which, generally speaking, requires a chapter 11 plan “to adhere to the order of priority entitlements against the debtor’s assets between classes of unsecured claims and equity interests under applicable non-bankruptcy law” and ensures that creditors are paid in full before equity owners retain anything. Charles Jordan Tabb, The Law of Bankruptcy 1166-67 (2d ed. 2009). In place of the absolute priority rule, the new subchapter V requires the debtor to pay disposable income to creditors for a period set by the court of three-to-five years. 11 U.S.C. § 1191(c)(2). In In re Patel, No. 09-39791-C-11, 2020 Bankr. LEXIS 2904 (Bankr. E.D. Cal. Oct. 15, 2020), a California bankruptcy court recently clarified this requirement, holding that “disposable income” means actual disposable income and that the definition includes revenue from all sources. The court also explained that the debtor owed a duty to account to the creditors concerning disposable income on a periodic basis.

Courts Interpret Who Qualifies To Restructure Under The New Subchapter V

To qualify for relief under subchapter V, a debtor must: (1) be a debtor under chapter 11; (2) be a “small business debtor” under section 101(51D) of the bankruptcy code; and (3) must elect to have subchapter V apply to its case. 8 Collier on Bankruptcy P 1180.02 (16th Ed. 2020). Section 101(51D) defines a “small business debtor” as “a person engaged in commercial or business activities (including any affiliate of such person that is also a debtor under this title 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 $2,725,625 . . . no less than 50 percent of which arose from the commercial or business activities of the debtor . . . .” The Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) temporarily raises the debt limit from $2,725,625 to $7,500,000. In re 305 Petroleum, Inc., Nos. 20-11593-JDW, 20-11594-JDW, 2020 Bankr. LEXIS 3008, *5 n. 5 (Bankr. N.D. Miss. Oct. 27, 2020). The debt limit does not, however, include contingent and unliquidated claims. See, e.g., In re Parking Mgmt., No. 20-15026, 2020 Bankr. LEXIS 2309 (Bankr D. Md. Aug. 28, 2020) (holding that lease rejection claims against the debtor and its obligation to repay Paycheck Protection funds are excluded from the debt limit determination because they are contingent and, in the case of the PPP loan, unliquidated).

The definition also does not include: (1) “any member of a group of affiliated debtors that has aggregate noncontingent liquidated secured and unsecured debts in an amount greater than” $7,500,000, (2) “any debtor that is a corporation subject to the reporting requirements under section 13 or 15(d) of the Securities Exchange Act of 1934 . . .;” or (3) any debtor that is an “issuer” as defined by the Securities Exchange Act of 1934.

Three recent decisions have further clarified these qualifications. A South Carolina bankruptcy court recently ruled that it is unnecessary for a debtor to be conducting business when filing its petition to qualify. In re Wright, No. 20-01035-HB Chapter 11, 2020 Bankr. LEXIS 1240 (Bankr. D.S.C. Apr. 27, 2020). The court explained that “[a]lthough the brief legislative history of the SBRA indicates it was intended to improve the ability of small businesses to reorganize and ultimately remain in business, nothing therein, or in the language of the definition of a small business debtor, limits application to debtors currently engaged in business or commercial activities.” Id. at *7 (internal footnote omitted) (emphasis in original). Similarly, a Louisiana bankruptcy court held that personal guarantees of a defunct business’s debts are enough to satisfy the qualifications. In re Blanchard, No. 19-12440, 2020 Bankr. LEXIS 1909 (Bankr. E.D. La. Jul. 16, 2020).

Finally, a Mississippi bankruptcy court found that the debt of the debtor’s affiliate — even where the affiliate did not itself qualify for subchapter V reorganization — is properly aggregated into the total debt to be weighed against the $7.5 million debt ceiling. In re 305 Petroleum, Inc., 2020 Bankr. LEXIS 3008. The court explained that “Congress made clear that a small business debtor cannot be a member of a group of affiliates whose aggregate debt exceeds $7,500,000,” and that the affiliate’s “status as a single asset real estate debtor has no impact on its status as an affiliate of the jointly administered debtors.” Id. at *7-8.

Courts Support Conversion and Redesignation From Existing Cases

The first published opinion to interpret the SBRA held that an existing chapter 11 debtor does not need to ask permission to convert its bankruptcy to subchapter V. In re Progressive Solutions, Inc., 615 B.R. 894 (Bankr. C.D. Cal. 2020); see also In re Trepetin, 617 B.R. 841 (Bankr. D. Md. 2020) (holding that converting from a chapter 7 to a subchapter V is also permissible). The court explained that “an amendment to a Bankruptcy Petition can be made at any time as a matter of course at any time before the case is closed” and the debtor may thereby redesignate under subchapter V. Id. at 900-01. The court explained, however, that “[i]f any vested rights of a debtor or any other party in interest would be in jeopardy, this Court concedes that rescheduling would likely be a violation of due process.” Id. at 899-900. The court also noted that the due process violation could be waived by the creditor holding vested rights if the creditor approved of a redesignation. Id.

Two noteworthy decisions have permitted redesignation notwithstanding the violation of procedural requirements. In re Ventura, 615 B.R. 1 (Bankr. E.D.N.Y. 2020); In re Twin Pines, LLC, No. 19-10295-j11, 2020 Bankr. LEXIS 1217 (Bankr. D.N.M. Apr. 30, 2020). The decisions allowed debtors in chapter 11 reorganization to convert to subchapter V despite the subchapter’s otherwise applicable procedural requirements, including the requirement for a status conference within sixty days of the order for relief (i.e. the date of a voluntary bankruptcy filing) and for the debtor to file a plan within ninety days from the order for relief. However, at least one court has held that the violation of such procedural requirements may prevent a debtor from converting its case. In re Seven Stars on the Hudson Corp., 618 B.R. 333 (Bankr. S.D. Fla. 2020).

Two noteworthy cases have addressed the effect that redesignation to subchapter V has on existing creditors’ committees. A California bankruptcy court held that redesignation may dissolve an existing committee. In re Bonert, No. 2:19-bk-20836-ER, 2020 Bankr. LEXIS 1783 (Bankr. C.D. Cal. Jun. 3, 2020). The court explained that a committee could survive redesignation if it showed “cause” to do so, which requires the committee to “demonstrate that its continued existence will improve recoveries to creditors, will assist in the prompt resolution of [the] case, and is necessary to provide effective oversight of the Debtors.” Id. at *9. However, another California bankruptcy court declined to allow the debtor to dismiss its reorganization and immediately refile under subchapter V in a case where counsel for the creditors’ committee had not yet been paid. In re Slidebelts, Inc., No. 2019-25064-A-11, 2020 Bankr. LEXIS 1777 (Bankr. E.D. Cal. Jul. 6, 2020).

Finally, an Oklahoma bankruptcy court recently held that debtor misconduct may be a bar to conversion. The court declined to extend the automatic stay in a converted case where the debtors paid counsel without authorization and spent estate assets that should have been in escrow. In re Crilly, No. 20-11637-SAH, 2020 Bankr. LEXIS 1718 (Bankr. W.D. Okla. Jun. 30, 2020). This misconduct depleted the estate’s value by $50,000. The Court also reasoned that confirmation was unlikely and the conversion’s purpose was to delay creditors’ recovery.

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