CARES Act: Expanded Small Business Reorganization Act Can Assist Distressed Businesses

On February 19, 2020, just a few months before the COVID-19 pandemic sent shockwaves throughout the business communities, the Small Business Reorganization Act (“SBRA”) became effective.  Now more than ever, as payroll protection loans and treasury funding appears to wane, small businesses should seriously consider whether leveraging the streamlined reorganization offered under the SBRA is a viable option to sustain operations and stave off liquidation during this period of economic shutdown.

In particular, the CARES Act expanded the debt limits for filing under the SBRA, from under $2.725 million to $7.5 million.  In doing so, Congress greatly expanded the availability of reorganization under the SBRA to businesses that would not have previously qualified.  However, the increased debt limits are only available to filers who commence a reorganization on or before March 27, 2021.  As a result, businesses who might otherwise not be eligible to reorganize under the SBRA should consider filing before March 27, 2021.

The SBRA is intended to reduce the barriers that once prevented small businesses from effectively reorganizing under Chapter 11.  Under “Subchapter V” of the Bankruptcy Code, a small business reorganization is streamlined by eliminating previously existing barriers, such as cumbersome reporting requirements, a lengthy and costly reorganization process, and limiting certain creditor rights under Chapter 11, such as “absolute priority,” and permissive modification of loans secured by a principal residence.  In addition, a Trustee is appointed to oversee the case and facilitate a consensual reorganization plan – in other words, to promote a plan that all impaired creditors approve. 

Businesses who are currently engaged in a Chapter 11 reorganization whose total debt (secured and unsecured) is less than $7.5 million are now eligible to file under Subchapter V, and existing eligible debtors in Chapter 11 may be able to convert to a Subchapter V petition, as recently held by a California Bankruptcy Court. 

In practice, Subchapter V alleviates some of the burdens of small business reorganization through the following mechanisms:

1. Automatic Appointment of a Trustee: Upon filing a Subchapter V petition, a Trustee is appointed to oversee the case, whose primary function is to “facilitate a consensual plan of reorganization” – in other words, a plan in which all impaired creditors vote to confirm the plan;
2. Absolute Priority Rule Eliminated: Creditors who are impaired under a plan of reorganization lose their absolute right to reject a plan, as the Subchapter V debt has significantly more power to “cram down” a non-consensual plan so long as the debtor contributes all of its disposable income for a period of 3 to 5 years, as the court may determine. The “absolute priority rule” refers to the requirement in Chapter 11 that impaired creditors must receive at least the value to which they would be entitled in a hypothetical Chapter 7 liquidation of the business; under Subchapter V the court has more discretion to determine what is “fair and equitable” under the circumstances;
3. New Value Rule Eliminated: Equity holders of a small business debtor need not provide “new value” to retain their equity interest if creditors are not fully paid. To confirm a reorganization plan, the only requires that the plan does not discriminate unfairly, is fair and equitable and, 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.
4. Administrative Expense Payments Delayed: Unlike a typical bankruptcy, a small business debtor may pay administrative expense claims over the term of the plan, rather than requiring the debtor to pay administrative expense claims – including claims for post-petition goods and services – on the effective date of the plan.
5. No Impaired Class Required: Under Subchapter V, a court may “cram down” a non-consensual plan even where no impaired class creditor has voted to confirm the plan.  Traditionally, at least one impaired creditor vote to confirm is required to cram down a Chapter 11 reorganization plan.
6. Discharge: Debtors under Subchapter V are entitled to a discharge, either upon confirmation (for consensual plans) or after the first three years of payment for non-consensual plans. As a result, the Creditor’s rights are immediately extinguished as to the pre-petition debt, and only the right to receive plan payments under the reorganization plan survives.
7. Principal Residence Loans Modified: Where a business owner borrows against their primary residence in order to finance the business, Subchapter V allows the debtor to modify such loans in the reorganization plan.  Conversely, a debtor may not modify a first-position purchase money mortgage.  

The Bottom Line

The Small Business Reorganization Act endeavors to facilitate the successful reorganization of viable small business by increasing process efficiencies, reducing costs and barriers, and providing flexibility to smaller businesses in distress.  In response to the pandemic, Congress greatly expanded the availability of the SBRA to a greater number of larger businesses; however, these protections are only available for a limited time and businesses should act quickly to consider whether taking advantage of this option makes business sense.

For more information, or for assistance with navigating the SBRA, please contact Leonard S. Spinelli, Chair of the Bankruptcy, Reorganization, and Creditor's Rights Group via email or via phone at 973.230.2085.