THE SMALL BUSINESS BANKRUPTCY BLOG
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.