Even thinking about getting through a Chapter 11 can be daunting for most small businesses because of the sizeable administrative expenses and challenges of plan confirmation.
Recognizing this, Congress recently enacted the Small Business Reorganization Act to provide a more streamlined and inexpensive process to businesses and individuals with primarily business debts of up to $2,725,625 starting in February 2020. This new process has several substantial benefits for small business debtors, but – before you elect this process over a traditional Chapter 11 – there are pitfalls to be considered as well.
The Act changes key aspects of Chapter 11 in favor of the debtor:
- Consent Not Required: In a traditional Chapter 11 case, plan confirmation requires the consent of at least one impaired class of creditors. Under the Act, the debtor can propose a plan impairing any and all creditors without obtaining any consent to do so.
- Can Keep Equity: The “absolute priority rule” generally prevents a plan from making a distribution to a more junior parties (e.g., shareholders) until the more senior parties (e.g., unsecured creditors) are paid in full. Shareholders could avoid this rule and keep their equity by providing a new capital contribution as part of the reorganization. Under the Act, this longstanding rule does not apply, and the debtor’s shareholders can retain their equity without providing any new value, reducing the reorganization’s cost to them.
- Reduced Disclosure: The Act removed the requirement for a full disclosure statement – which can require substantial legal costs and information about the debtor and the plan – in favor of a reorganization plan accompanied by a liquidation analysis and financial projections. In a regular Chapter 11 case, the small business debtor has to ask the court to waive the disclosure statement requirement.
- Reduced Near Term Costs: A Chapter 11 case can run up five to six figures in administrative expenses between the various professionals’ fees and costs. Under the Act, these administrative expenses can be paid over time via the plan rather than on the plan’s effective date, removing what can be a serious obstacle to plan confirmation.
- Increased Retention of Control: Under the Act, the debtor has the exclusive right to file a reorganization plan, preventing other parties from proposing their own reorganization or liquidation of the debtor. That said, while no one else can file a plan, the debtor must still file it within 90 days unless the court grants an extension on account of circumstances outside the debtor’s control.
These advantages come a substantial cost, however:
- Distribution of Projected Disposable Income: The plan must provide for the distribution of all of the debtor’s “projected disposable income” over a three year term, with that term increasing up to a maximum of five years (for example, if a longer term is necessary to provide the creditors with more than what they would obtain in a liquidation). The debtors’ “projected disposable income” is defined as all income “not reasonably necessary” for “the continuation, preservation, or operation of the business,” the maintenance of the debtor and his or her dependents, and any domestic support obligations. This business expense language raises concerns that should be discussed with counsel about how a debtor can expend its revenues, including whether – for example – a debtor can re-invest its revenues to grow the business.
- Need to Complete Entire Plan: In order to obtain a discharge, the debtor must complete all of the plan payments for the full three to five year period. Chapter 13 likewise provides for three to five year plans for individuals, but the majority of Chapter 13 cases fail. The Act contains language permitting the plan to be modified after confirmation, but only if “circumstances warrant” as determined by the court. Before opting to proceed under the Act, the small business debtor must consider whether this timeframe is workable for its business.
- Appointment of Trustee: Just like in a Chapter 13 case, a trustee is appointed in every case. The trustee supervises the debtor and its finances, and also appears at most important hearings in the case. The trustee also administers the payments made under the plan. If the debtor is removed from possession, the trustee takes over the business operations and reorganization.
Overall, a small business debtor or sole proprietor needing to reorganize will have the opportunity to do so at less cost than in a traditional Chapter 11. That said, the business must consider whether the benefits are worth the cost of committing its “disposable” income for years to plan payments.
About the Author: Jaime Leggett practices in the areas of bankruptcy and complex commercial litigation. His experience includes prosecuting director and officer liability claims; representing trustees, creditors, equity holders, and debtors in bankruptcy proceedings; federal and state court commercial litigation; and trials in federal, bankruptcy, and state courts nationwide.