Choosing The Right Type Of Bankruptcy & The SBRA

The types of bankruptcy available to a business owner depend on the structure of the business. If it is an individual operating a business in their own name (not through an LLC or corporation), then that individual is going to have all the available options for an individual, which include Chapter 7 liquidation and Chapter 7 personal reorganization, Chapter 11 (for complex business reorganization), or Subchapter V of Chapter 11.

Most small and medium-sized businesses are operated through an entity, whether that be a corporation or an LLC. The corporation or LLC does not have access to Chapter 13 bankruptcy, but it does have access to Chapter 7 bankruptcy, which would be a simple dissolution of that business. It would also have access to a Chapter 11 bankruptcy.

Within Chapter 11 bankruptcy, an LLC or corporation that meets certain requirements could be eligible for a Subchapter V small business reorganization depending on the amount of debts and assets, and what the business does. For those LLCs, the decision will be between Chapter 11 and Chapter 7. If Chapter 11 reorganization is chosen, then the decision will be between a standard Chapter 11 (a small business reorganization) and Subchapter V of Chapter 11. There is also a separate category for a small business debtor under Chapter 11 if that debtor does not fit or does not choose to fit under the Small Business Reorganization Act (SBRA).

One of the best features of the SBRA and Subchapter V is the removal of the absolute priority rule. That rule provided that no junior class of creditors could be paid anything in the bankruptcy unless all senior classes of creditors were fully paid. Typically, the priority of the classes goes: secured creditors, unsecured creditors, and last, equity holders (i.e., owners). The owners come in last. Practically speaking, this meant that unless secured and unsecured creditors were fully paid in the bankruptcy, the business owners could not retain their equity in that business. If the owners cannot retain their ownership, then this rule, in essence, removed any incentive for a small business owner to go through the bankruptcy process.

With that rule being removed under Subchapter V, the small business owner can take the business through Subchapter V of Chapter 11 then come out the other side with debt restructured, satisfying all secured and unsecured creditors, even if those creditors are not paid in full, and yet still retain the owner’s equity in the business. The SBRA incentivizes qualified small and medium-sized businesses to go through the bankruptcy process, thereby allowing them to survive.

The Small Business Reorganization Act (SBRA)

The Small Business Reorganization Act of 2019 (the “SBRA”) was passed in 2019 and was intended to create a more favorable route for small businesses to use the bankruptcy protections available under Chapter 11. It includes a streamlined path for a business, or for an individual operating a business or operating as a business, to go through chapter 11 and receive a discharge. Before this act, small businesses could not benefit as much from chapter 11, and this led to many business liquidations and closures. The intent of the SBRA is to help small businesses survive through bankruptcy so small and medium-sized businesses can use the bankruptcy process effectively.

Qualifying For The SBRA?

The SBRA introduced a new subchapter V to Chapter 11, which created a new definition for small business debtor. According to the new definition, a small business debtor must still be engaged in commercial business but only needs 50% or more of its debt to arise from that commercial business. The SBRA sets a debt “ceiling” for qualification also. The SBRA excludes single asset real estate entities from qualifying. It also excludes any public companies.

Provisions Set Forth In The SBRA

The SBRA created big changes to help small businesses, including an increase in the speed of cases. The debtor must file a plan within 90 days of the petition date. In addition to the increased efficiency, there is also increased authority for the debtor: only the debtor may file a plan. Under the SBRA, there are no competing plans allowed by creditors.

Additionally, and possibly most important, the SBRA eliminates the absolute priority rule, which required payment in full to senior creditors before any junior creditors could receive any payment. Equity owners (i.e., the business owners) were at the bottom. Unless the business paid every creditor in full or the owners paid additional cash into the bankruptcy to “repurchase” their equity, the equity holders did not get to keep their equity/stock. The SBRA gives business owners a much better chance to keep their equity.

The SBRA also includes the appointment of a trustee whose purpose is to help the debtor create and negotiate a consensual (agreed upon) plan of reorganization. Last, there is no quarterly US trustee or bankruptcy administrator fee, so the debtor will not have to make those payments.

SBRA Strikes A Balance Between Chapter 7 And Chapter 11 Bankruptcies

What the SBRA really does is provide an avenue for small business debtors to avoid chapter 7 and use chapter 11. Before those small businesses were not able to use chapter 11 due to all of its costs and challenges. Prior to the SBRA, small business debtors would often struggle to survive through a chapter 11.

SBRA Better Enabling Businesses To Survive Bankruptcy

There are several ways the SBRA helps small businesses survive a bankruptcy and retain control of their operations. The SBRA got rid of the “absolute priority rule,” ensuring that the business owner has a better possibility of keeping his or her equity. Now, assuming the debtor pays all its projected disposable income, the equity holders are entitled to keep their equity and ownership. This gives small business owners a chance to enter bankruptcy, restructure their debt, and keep their equity. That chance was not there before SBRA.

Another way the SBRA helps small business is by establishing a shorter period for filing a plan and allowing only the debtor to file a plan. The debtor must file a plan within 90 days of the petition date, instead of the previous 300, and there are much fewer costs that can be incurred in 90 days. There can be no competing plan filed by a creditor. Another great help provided by the SBRA is the elimination of creditors’ committees altogether, which greatly reduces expenses for small businesses.

Before The SBRA Options For Small Business Bankruptcies

Before the SBRA, chapter 11 included provisions for what it defined as a small business case or small business debtor. But with the absolute priority rule still in place, there was little incentive for a small business to go through the chapter 11 process. The owners could rarely keep their equity. Often, such businesses would just gradually die out.

Now, there is a way for owners to enter bankruptcy, receive protection, restructure existing debt, and still come out on the other side of the bankruptcy with their ownership and working business. This saves employees’ jobs, contracts with clients, and relationships with vendors.

The Costs Of Chapter 11 Bankruptcies For Small Businesses

Before SBRA, Chapter 11 had many additional costs, including quarterly trustee fees, liquidation costs, fees for creditors’ committee counsel, fees for the equity holder’s counsel, if applicable, and costs for other third parties to assist with reorganization which can sometime take years. The combination of those costs with the costs of lawyers, accountants, and other standard costs made it almost impossible for small businesses who were already struggling to make it through a Chapter 11 bankruptcy. While legal fees still apply, the SBRA removed many of the other costs, giving small businesses a chance to survive.

The Advantage of No Committee Of Creditors In A Bankruptcy Filed Under The SBRA

Under the subchapter V in Chapter 11, there will be no committee of creditors. This provides several advantages, including the reduction of overall costs, since the estate will not need to pay counsel for the creditors’ committee.

SBRA’s Amendments Streamline The Plan Confirmation Process

The SBRA drastically speeds up the process of a chapter 11, as it requires that a plan be proposed within 90 days, as opposed to the old requirement of 300 days. This means the bankruptcy will be shorter, which translates to fewer costs. Subchapter V also removes the requirement for a debtor to file a disclosure statement along with the plan, which would typically require approval, and slow the process.

Relaxing The Requirements To Confirm A Plan

The SBRA makes the confirmation of a plan easier in a couple different ways. First, the trustee who was appointed in a subchapter V case is different from other trustees you might see in some other chapters. Typically, in a chapter 11, the debtor in possession acts as the trustee. In other words, the debtor is both the trustee and the debtor in possession. In subchapter V, the debtor remains the debtor in possession but there is also a trustee whose goal is to help the debtor create a consensual plan. A “consensual plan” is a plan which is agreed upon by the debtor and all classes of creditors.

Subchapter V allows for confirmation of a plan even over the objections of all the classes of creditors, whereas in a typical chapter 11, the debtor is required to obtain the consent of at least one class of creditors whose rights are being negatively affected to approve the plan. As previously noted, the SBRA also eliminates the “absolute priority rule,” which means there is a higher likelihood of the owners retaining their equity in the discharged entity, which increases the incentives for owners to come up with a workable plan that can be confirmed.

The CARES Act And The SBRA

The CARES Act addressed multiple matters, including temporary changes to the SBRA in subchapter V. The CARES Act increased the debt limit requirement to qualify as a small business debtor from $2.7 million to $7.5 million. Therefore, a much larger percentage of potential business debtors qualified under the SBRA due to the CARES Act (at least while the CARES Act remains in force).

The CARES Act changes to the SBRA are temporary, and effective until March 27, 2022. After that, the debt limit for subchapter V debtors may return to the previous $2.7 million limit. However, comments from judges and others involved in this process indicate that Congress may decide to make this increased limit permanent, but there is no guarantee.

Filing Under The CARES Act And SBRA

For most people, this is the ideal time to file if your debt is less than the $7.5 million limit increased by the CARES Act, because, as stated previously, this higher debt limit is temporary. If you are considering bankruptcy, I suggest an evaluation of the business prospects performed by counsel and accountants to determine if bankruptcy would be the best route, and which chapter to file. Each situation is unique and must be thoroughly examined to decide the best course of action.

Stakeholder Considerations

Whether all stakeholders will need to agree about filing for bankruptcy is a matter of non-bankruptcy law. Each of the entities is going to be a creature of the state law under which it was created. An LLC in Alabama is generally going to be governed by its operating or LLC agreement. A common provision of an operating agreement would specify the vote needed for a business to elect to dissolve or take some action outside the ordinary course of business. The LLC agreement would also dictate what the business must do to decide to enter a bankruptcy.

In the absence of an agreement which specifies this information, the issue would be governed by the provisions of the Alabama Business and Non-Profit Entity Code related to the particular type of entity (corporation, LLC, etc.). In most instances, approving a bankruptcy filing will take at least a majority of the voting interests, and may require a super-majority (whether that be 60 percent, 66 percent, 75 percent, etc.). State law documents pertaining to the specific entity would have to be reviewed to determine what that entity must do to enter the bankruptcy.

For more information on The Right Type of Bankruptcy & The SBRA, an initial consultation is your next best step. Get the information and legal answers you are seeking by calling (205) 506-3354 today.