THE SMALL BUSINESS BANKRUPTCY BLOG
Muddied Waters: Courts Disagree Whether a Debtor Must Be Operating to Qualify for Subchapter 5 Relief
The SBRA defines a qualifying "debtor" as "a person engaged in commercial or business activities." 11 U.S.C. § 1182(1)(A). A few months ago, I cited In re Blanchard, No. 19-12440, 2020 Bankr. LEXIS 1909 (Bankr. E.D. La. July 16, 2020), In re Wright, No. 20-1035, 2020 Bankr. LEXIS 1240 (Bankr. D.S.C. Apr. 27, 2020), and In re Bonert, No. 2:19-BK-20836, 2020 Bankr. LEXIS 1783 (Bankr. C.D. Cal. June 3, 2020). These cases supported the position that current operations are not necessary for a debtor to qualify under the SBRA. In other words, if the business is no longer operating but the debtor files bankruptcy to address residual business debts, then the debtor is "engaged in commercial or business activities" and thus may still qualify for Subchapter V relief.
But not everywhere. . .
In In re Thurmon, 2020 Bankr. LEXIS 3422 (Bankr. W.D. Mo. Dec. 8, 2020), the court sustained the United States Trustee's objection to the debtors' Subchapter V election because the debtors had ceased their business operations prepetition, sold their assets, and had no intention of resuming operations. Because the SBRA does not define "engaged in commercial or business activities," the court looked to analogous cases in Chapter 12 which require family farmers to "conduct" farming operations to qualify for relief under Chapter 12. After considering these cases, the court found that the Thurmons were not engaged in commercial or business activities when they filed bankruptcy because they had already sold the business with no intent to restart it and were otherwise not active or involved in any commercial or business activities. From a practical standpoint, the decision was not a disaster for the Thurmons because the court nonetheless confirmed the plan under a traditional Chapter 11 analysis; however, it could have been very difficult for them had there been other issues.
So, what is the work around in a case where the debtor is selling its assets and ceasing operations? File bankruptcy before the sale of the business assets and include the sale as part of the plan.
Whistle past the Graveyard, Not into It: Grave Mistakes That Small Businesses Make in Difficult Times (Part 1—Waiting Too Long to Obtain outside Help)
Financially distressed small businesses—no matter the industry—seem to make many of the same mistakes before and during difficult times. In the coming weeks, I am going to write a few short posts identifying and describing some of these mistakes. Not every distressed business makes these mistakes, but if you’re a business owner, or if you advise one, or if you’re married to one, you should be cognizant of these issues.
1. Waiting Too Long to Get Outside Help
Perhaps the most common mistake made by distressed businesses is waiting too long to get outside help. The business undertakes heroic efforts to stay on top of its debt service—which is admirable and often necessary—instead of using a portion of its funds to retain a financial advisor and attorney to fundamentally address and hopefully solve the problems experienced by the company. Often, a small business owner has worked years to build up a nest egg for retirement. All too often, when times get rough, that business owner will pour his or her retirement funds back into supporting the business. The owner hopes that this influx of capital will enable the business to “just get past the next [insert number] of weeks.” As the weeks turn into months and additional personal funds are transferred , the business is under constant pressure from its lenders, landlords, and vendors, and the owner is distracted from doing what he or she does best (i.e., delivering a great product or service). Often, the storm is weathered, the situation improves, and the business turns the corner, although the owner has substantially less financial security for retirement. Sometimes, however, the business never turns the corner, the owner’s retirement funds are depleted, personal credit cards are at their limits, the personal residence has a mortgage or home equity loan against it, and the business cannot even afford a Chapter 11 turnaround. The owner and his or her spouse feel that they have lost all that they have worked for. Had the owner sought outside professional assistance earlier, then a Chapter 11 or out-of-court workout may have bought time necessary to permit the business to turn the corner (instead of using the owner’s retirement accounts, personal credit, and personal assets). Two types of assistance are often helpful for a struggling business: (1) an outside financial consultant and (2) a business bankruptcy lawyer.
A competent financial consultant might help in a number of ways: (1) a comprehensive “health check” of the business, (2) developing and implementing a plan back to profitability, (3) finding potential investors or other outside financing, or (4) finding a buyer. The financial consultant’s business health check might include:
The business bankruptcy lawyer can also assist in a number of ways. The attorney can assist in negotiations with creditors so that there is not a rush to the courthouse to dismantle the business. Further, the fact that the business has retained competent bankruptcy counsel can lend credibility to a situation where trust has been diminished to due previously broken promises. The attorney can assist in many ways, including the following:
Unfortunately, too many business owners wait far too long to obtain outside help. For example, without receiving outside legal counsel, a business owner might put a half million dollars into his business to buy time from creditors because a turnaround takes longer than anticipated. Eventually, the owner’s personal financial resources are depleted and the business either liquidates or lands in a Chapter 11 filing. At that point, there’s a good chance that the owner and his spouse will be in bankruptcy, too. Rather than investing the family’s life savings to buy time and maintain the status quo, the owner should have spent a fraction of that money and put the business into Chapter 11, which would have bought 3 to 5 years to turnaround the business (with the family’s personal assets still intact). If this situation sounds like you, or spouse, or client, then consider getting help from a professional who has experience with business bankruptcy. Most lawyers have free initial consultations.
Finally, there is an important deadline in March of 2021 which will freeze many businesses out from taking advantage of the Small Business Reorganization Act of 2019. So, please be aware of this and, if you are a business owner meeting with a bankruptcy attorney, please ask your lawyer about the deadline.
The Small Business Reorganization Act of 2019 (the “SBRA”) added new Subchapter V to Chapter 11. The SBRA offers small business debtors a streamlined Chapter 11 procedure that should be less costly and time-consuming than a traditional case, and it offers the business owner a better opportunity to retain his or her company going forward. To be eligible for Subchapter V, a debtor must have “noncontingent liquidated secured and unsecured debts as of the date of the filing of the petition . . . in an amount not more than $7,500,000.” 11 U.S.C. § 1182(1)(A). This debt ceiling will fall back down to approximately $2.7 million in the spring of 2021.
Debt limitations are also features of Chapters 12 and 13, and they are the subject of litigation in those chapters. Unquestionably, the debt limitation will be the occasional subject of Subchapter V litigation as well. A recent case provides timely guidance for practitioners, including a court’s view on how PPP loans are treated under § 1182. In In re Parking Mgmt., No. 20-15026, 2020 Bankr. LEXIS 2309 (Bankr. D. Md. Aug. 28, 2020), the debtor had debts of almost $9,000,000, and its eligibility under subchapter V was questioned by the United States Trustee and a major creditor. However, the debtor argued that two types of its debt were unliquidated and/or contingent and thus should be removed from the debt limit calculation: (1) lease rejection damages and (2) the debtor’s obligation to repay its PPP loan. If these debts were found to be contingent or unliquidated, then the debtor would be eligible for a Subchapter V filing.
The lease rejection damages arose simply from the debtor’s decision to reject 12 leases as part of its first day filings. The court found such damages to be contingent. Even though § 365 treats lease rejection damages as a prepetition breach of contract, the rejection is not effective until court approval. In Parking Mgmt., the court held that any lease rejection claims were contingent obligations until the court approved the rejection. Consequently, the court held that such claims are not considered in determining the debtor’s eligibility for Subchapter V.
The debtor also listed a $1.8 million prepetition PPP loan that had not been repaid as of the petition date. To determine whether the debtor would be eligible for Subchapter V, the court had to decide whether the PPP is a noncontingent, liquidated debt as of the petition date. The court reviewed the history and the purpose of the Paycheck Protection Program, which includes loan forgiveness under certain circumstances. The court determined that the debtor's liability to repay the PPP is dependent on the debtor using the funds for ineligible expenses or failing to meet employee retention criteria. Because the debtor's liability to repay the PPP relies on some future extrinsic event which may never occur, the court determined that the obligation was contingent as of the petition date. The court further found that the PPP debt was unliquidated as of the petition date because it was not then known whether the debtor would use the PPP funds for ineligible expenses or would fail to maintain employee staffing levels in accordance with the PPP. Accordingly, the PPP obligation was not included in the Subchapter V debt limits and the debtor was eligible to take advantage of the SBRA.
Because so many small business debtors will have taken advantage of the PPP, In re Parking Mgmt. may be an important case to help debtors stay under the debt limitations of Subchapter V.
Some debtors with a pending Chapter 11 have made a small business election later in the case; others have opted to dismiss, refile their Chapter 11, and make the election upon refiling. It's a tactical decision. Here's a case that gives the practitioner some food for thought.
The SBRA is a great resource to assist a distressed business, but it imposes deadlines to keep the case moving expeditiously. For example, a plan must be proposed within 90 days of the order for relief. When a debtor has a case pending and later elects to proceed under Subchapter V, we have seen courts reset the deadlines. See, e.g., In re Twin Pines, LLC, No. 19-10295-j11, 2020 Bankr. LEXIS 1217 (Bankr. D.N.M. Apr. 30, 2020); In re Ventura, 615 B.R. 1 (Bankr. E.D.N.Y. 2020); In re Bello, 613 B.R. 894 (Bankr. E.D. Mich. Mar. 27, 2020). However, a recent decision from the Southern District of Florida shows that this outcome is not a given—the court dismissed the case because the deadlines had already passed when the election was made.
In In re Seven Stars on the Hudson Corp., No. 19-17544-SMG, 2020 Bankr. LEXIS 2106 (Bankr. S.D. Fla. Aug. 7, 2020), the debtor's Chapter 11 was pending for about a year before the debtor made its Subchapter V election. Subchapter V, however, requires a debtor to file a plan not later than 90 days after the order for relief (§1189(b)), and it requires the court to hold a status conference not later than 60 days after the order for relief (§ 1188(a)). In Seven Stars, the order for relief was entered on June 5, 2019. Thus, upon amending its petition to elect to proceed under Subchapter V more than a year into its case, the debtor immediately put itself in default of the requirements of §§ 1188(a) and 1189(b).
After making the election, the court dismissed the case because the deadlines had already passed and the debtor failed to show cause for extending them. The court noted that, to extend the deadlines, the debtor must show “circumstances for which the debtor should not justly be held accountable.” The court stated:
Where a debtor elects to proceed under Subchapter V after the statutory deadlines have passed, it cannot be said that the need for an extension of these deadlines is attributable to circumstances for which the debtor should not justly be held accountable. The debtor should justly be held accountable for these circumstances; the debtor made this election after the deadlines expired. That decision by a debtor should not foist upon creditors all of the added powers of a Subchapter V debtor without one of the most significant protections afforded to creditors under the SBRA — that the case proceed expeditiously.
Id. at *21-22. Although the election was made more than a year of the bankruptcy petition and only three weeks after the court ruled that the debtor incurred a $130,000 administrative claim, the court did not find a lack of good faith on the part of the debtor. The court found:
Where a debtor elects into Subchapter V after expiration of the statutory deadlines, however, the debtor should justly be held accountable for those circumstances, because the debtor created them. It was the debtor that made the decision to elect into Subchapter V after expiration of these deadlines. No circumstances beyond the debtor's control caused the debtor to make that decision.
Id. at *18-19.
Although the case has been dismissed, I suspect that the debtor will refile the Chapter 11 and make the Subchapter V election upon refiling.
The Courts Are Providing Clarity: Non-operating Businesses and Their Owners Also Qualify under the Small Business Reorganization Act
Another case has held that nonoperating businesses and their owners may qualify for relief under the Small Business Reorganization Act of 2019. The SBRA defines a qualifying "debtor" as "a person engaged in commercial or business activities." 11 U.S.C. § 1182(1)(A). There has been some debate as to whether this language requires a debtor to be currently engaged in commercial or business activities. Three courts have now found that nothing in the legislative history of the SBRA or in the statute itself limits its application to debtors currently engaged in business or commercial activities. The latest case is In re Blanchard, No. 19-12440, 2020 Bankr. LEXIS 1909 (Bankr. E.D. La. July 16, 2020)(finding that current operations are not necessary to qualify under the SBRA but noting that a majority of the debtors' debts stemmed from operation of both currently operating businesses and non-operating businesses). The other two cases are In re Wright, No. 20-1035, 2020 Bankr. LEXIS 1240 (Bankr. D.S.C. Apr. 27, 2020) (finding that a debtor who sought to address residual business debt he incurred from non-operating companies to be "engaged in commercial or business activities" without reliance on a coexistent case) and In re Bonert, No. 2:19-BK-20836, 2020 Bankr. LEXIS 1783 (Bankr. C.D. Cal. June 3, 2020)(finding proper an election to proceed under the SBRA to address the debtors' liabilities stemming from their prior operation of a bakery).
Planning to Dismiss an Existing Chapter 11 and Refile to Elect Subchapter V? Read In re Crilly, and Don't Overplay Your Hand
The SBRA was designed to broaden the opportunity for small businesses to successfully utilize the benefits of chapter 11 and it created Subchapter V for small business debtors. The SBRA gives the small business debtor a better chance to unburden itself from unmanageable debt and to make a fresh start. It costs less than a traditional Chapter 11, it proceeds at a rocket’s pace compared to a traditional Chapter 11, and it permits business owners to retain their ownership interests. Consequently, businesses and their owners elect Subchapter V when possible. In one recent case, the debtors decided to take advantage of Subchapter V by dismissing their pending traditional Chapter 11 and then refiling with a Subchapter V election. It did not work out the way the debtors had hoped.
One advantage of bankruptcy is that the “automatic stay” under 11 U.S.C. § 362 goes into effect upon the commencement of the case and it lasts until the case is closed or dismissed. The automatic stay prohibits most creditors from continuing collection activities against the debtor, and the stay can provide welcome relief to the debtor as it formulates a plan to bring its operations back to profitability. In In re Crilly, No. 20-11637-SAH, 2020 Bankr. LEXIS 1718 (Bankr. W.D. Okla. June 30, 2020), the debtors had a traditional chapter 11 pending, but then decided to dismiss and refile to take advantage of Subchapter V. However, because the Crillys had a prior bankruptcy case pending during the year preceding the filing of their new bankruptcy case, the automatic stay of 11 U.S.C. § 362(a) was set to terminate thirty days after the filing of the second case unless the Crillys could establish that the filing of the second case was in good faith. Accordingly, the debtors filed a motion seeking a continuation of the automatic stay, arguing that the second case was filed in good faith. The United States Trustee ("UST") and two creditors objected to the Motion—claiming the second case was filed in bad faith. The objecting creditors had a previous motion for relief from the automatic stay pending at the time that the original case was dismissed.
The Court found in favor of the UST and the objecting creditors. The Court noted that there is a presumption of bad faith in a second filing, and this presumption works in favor of all creditors unless the debtors demonstrate (1) there has been a substantial change in their financial or personal affairs or (2) the second case will be concluded with a confirmed plan they can perform. Additionally, if a creditor had a motion for relief from stay pending when the original case was dismissed, then there is a presumption of bad faith with respect to that particular creditor, and the burden is on the debtor to overcome the presumption. In this case, the Court considered the totality of the circumstances and found that the Crillys could not meet their burdens. The second case was filed just six hours after the original case was dismissed. So, the debtors could not show that they experienced a substantial change in their financial or personal affairs in those few hours. Further, the original case has a long history, with six amended plans and a previous order denying confirmation for lack of feasibility. Moreover, the Subchapter V Trustee testified that he did not have high hopes for achieving a consensual plan. The two creditors who had objected were family members—Mrs. Crilly’s mother and stepfather. Sometimes, making a deal with one’s parents or in-laws can be infinitely more difficult than making a deal with a bank. The Court found that the disgruntled family members held 90% of the debt and a deal was unlikely, that the Crillys could not confirm a plan during the original case, that they paid their attorney $50,000 in the few hours between the first case and the second case, and that they manipulated the Bankruptcy Code for twenty months in the first case. So, the Court did not extend the stay.
This case is an extreme example, but debtors and their professionals need to be aware of the potential pitfalls in any case, and this case provides an interesting discussion on the interplay between the SBRA and § 362(c)(3).
The SBRA deals the debtor a pretty good hand, but you still have to know how to play it.
Testing the Limits of the SBRA: Can a Debtor Use the SBRA to Lien Strip a $1.5 Million Mortgage on Her Home? Maybe....
One advantage of the SBRA is that it permits qualifying debtors to modify (i.e., strip) the mortgages from their residences under certain circumstances. A small business debtor will now be permitted to modify a mortgage secured by a residence if the proceeds of the loan were used for the small business rather than for acquiring the residence. So, what happens in the grey area where the residence also serves as a business? The case of In re Ventura, 2020 Bankr. LEXIS 985 (Bankr. E.D.N.Y. Apr. 10, 2020) took up the issue and held in favor of the debtor.
Ventura involves the eligibility of a debtor whose primary debt was a $1.5 million mortgage on her home which also served as a bed and breakfast business. The debtor operated a bed and breakfast out of her home, and she had a Chapter 11 pending when the SBRA went effective. The debtor then elected Subchapter V because her primary debt was the mortgage on her home, and she had a bright lawyer who thought that the SBRA might enable the debtor to strip the mortgage. Under Subchapter V, a claim secured by the principal residence of the debtor may be modified if the indebtedness was used primarily in connection with the small business—that provision is not available in a typical Chapter 11. Over the objection of the US Trustee and the secured creditor, the court found that the mortgage was primarily a business debt because her home also served as a bed and breakfast, and the court permitted the debtor to make the small business election. So. . . it appears that the court might need to resolve a lien stripping dispute in the near future. I suspect that we are going to see the principles set forth in Ventura applied elsewhere.
I love seeing cases which explore the limits of this new law.
A small business debtor is defined as one that is engaged in commercial or business activities and has no more than $2,725,625 in noncontingent liquidated secured and unsecured debt (excluding debts owed to affiliates or insiders), not less than 50 percent of which arose from the commercial or business activities of the debtor. 11 U.S.C. § 101(51D). The Coronavirus Aid Relief and Economic Security Act (“CARES”) increases the eligibility threshold to $7,500,000; however, the eligibility threshold will return to $2,725,625 after one year. But what does it mean to be "engaged in commercial or business activities?" Are the benefits of the SBRA foreclosed to businesses that have ceased operations? The court in In re Wright, 2020 Bankr. LEXIS 1240, at *2 (Bankr. D.S.C. Apr. 27, 2020), held that the debtor could still make the Subchapter V election even if business operations had ceased.
In Wright, the debtor was an individual who owned two failed businesses. The businesses ceased operations in 2018. Those businesses were not debtors. 56% of the debtor's debts were business debts relating to those defunct businesses. He elected to proceed under Subchapter V. The US Trustee objected because the debtors’ businesses were not operating at the time of the filing and there was no hope of those businesses ever operating again. Therefore, the US Trustee argued that the debtor was not engaged in business activities. The court found in favor of the debtor and held that “he is engaged in commercial or business activities by addressing residual business debt and he otherwise meets the remaining requirements under § 101(51D).” Thus, if the non-operating debtor otherwise qualifies for the Subchapter V election and is addressing residual business debts, the debtor has a strong argument with supporting caselaw that the debtor can take advantage of the SBRA.
Relief for the Small Business: The Coronavirus Aid Relief and Economic Security Act (“CARES”) and the Small Business Reorganization Act of 2019 (“SBRA”)
The coronavirus pandemic is placing unprecedented stress on small businesses. Consequently, a key provision in the Coronavirus Aid Relief and Economic Security Act (“CARES”) provides small businesses with greater access to bankruptcy reorganization. CARES amended the Small Business Reorganization Act of 2019 (“SBRA”) and increased the eligibility threshold for businesses filing under new subchapter V of chapter 11 from $2,725,625 of debt to $7,500,000. The eligibility threshold will return to $2,725,625 after one year.
SBRA became effective on Feb. 19, 2020, and added a new section to chapter 11 to provide a better opportunity for small businesses to successfully restructure and save jobs. For qualifying small businesses, the Act will ease the financial burdens of bankruptcy by streamlining the process to confirmation of a plan of reorganization. The debtors who qualify will find the small business Chapter 11 far less expensive and less daunting than those who do not. Significantly, SBRA has removed the “absolute priority rule” from small business Chapter 11s, thereby allowing business owners to retain their equity interests even if creditors are not paid in full.
SBRA includes the following provisions:
- Elimination of the Absolute Priority Rule for Small Business Debtors: Under the “absolute priority rule,” equity interest holders are not permitted to retain their equity under a plan unless all senior claims are paid in full. This rule often dooms a company to liquidation, particularly in cases of smaller companies where continued participation by current equity holders is vital to the reorganization effort. If a small group of owners cannot retain their ownership because all creditors cannot be paid in full, then there is no choice but to try to sell the operations of the business as a going-concern, find new investors or otherwise inject new equity into the company, or simply liquidate. Under SBRA, the owners may retain the business if (in addition to all of the other requirements for confirmation) the plan: (i) does not discriminate unfairly, (ii) is fair and equitable, and (iii) provides that all of the debtor’s projected disposable income will be applied to payments under the plan or the value of property to be distributed under the plan is not less than the projected disposable income of the debtor.
- Streamlining the Process to Confirmation. SBRA removes several procedural and financial burdens associated with a typical Chapter 11 case. For example, no unsecured creditors committee (whose attorneys, financial advisors, and other professionals must be paid by the debtor) will be appointed unless ordered by the court. Further, the debtor has the exclusive right to propose a plan of reorganization. Moreover, the Debtor is not required to obtain approval of a disclosure statement or solicit votes for its plan. SBRA also provides a 90 day deadline within which to file a plan—an accelerated time table which may reduce the administrative costs of a case.
- Delayed Payment of Administrative Expense Claims. Under the typical Chapter 11 reorganization, administrative claims must be paid upon the effective date of the confirmation of the plan. Administrative claims (typically claims for postpetition goods and services provided to the debtor) can be substantial and can be a significant hurdle to confirmation. SBRA removes this requirement and now permits a small business debtor to stretch out the payment of administrative claims over the term of the plan.
- Appointment of a Trustee. SBRA provides for the appointment of a trustee for the small business’s bankruptcy estate. This trustee will not have the plenary powers of a Chapter 7 trustee, but instead acts as a facilitator—watching over the process to ensure that is not abused, helping to guide the debtor to a confirmable plan, and monitoring the debtor’s progress towards consummation of its plan of reorganization. The trustee has the authority to investigate the financial affairs of the debtor and to object to the allowance of proofs of claim, shall appear and be heard at plan confirmation, and shall attempt to facilitate the development of a consensual plan of reorganization.
- Residential Mortgage Modification. SBRA removes the prohibition against the modification of residential mortgages. A small business debtor will now be permitted to modify a mortgage secured by a residence if the proceeds of the loan were used for the small business rather than for acquiring the residence.
Given their size and limited financial resources, small business debtors have generally been unable to benefit from the small business provision in Chapter 11. CARES and SBRA will assist small businesses to a successful reorganization, thereby preserving jobs, maintaining business relationships, preserving economic value, and resulting in higher distributions to creditors.