Small Business Bankruptcies Under Subchapter V
Originally published in the New York Law Journal on January 19, 2021
A new provision of the Bankruptcy Code covering small businesses took effect in February 2020. Referred to as “Subchapter V,” it provides a streamlined process for reorganization of businesses under a certain debt threshold. 11 U.S.C. §§1181-1191. As part of the CARES Act response to the coronavirus passed in March, Congress amended Subchapter V through March 2021 only, to raise the initial debt threshold of $2,725,625 to $7.5 million.
Within 90 days of a bankruptcy filing, Subchapter V debtors must file a plan providing for payments to creditors over a three to five-year period. The payments must equal the debtor’s “disposable income,” defined below. 11 U.S.C. §1191(d). Subchapter V eases or eliminates some of the critical hurdles faced by Chapter 11 debtors in confirming a plan. Under Subchapter V, normally no disclosure statement is required, no official creditors’ committee is formed, administrative expenses may be paid after a plan is confirmed, the debtor has an unlimited exclusive right to file a plan, and a vote of creditors is not required to confirm a plan. Also, unlike under Chapter 11, debtors may retain equity in their business without the consent of creditors even if creditors are not paid in full. This article focuses on issues revealed in case law since the law took effect.
In re Serendipity Labs, 2020 Bankr. LEXIS 3164 (Bankr. N.D. Ga. Oct. 19, 2020) determined a debtor was ineligible for Subchapter V because it was an “affiliate” of an “issuer” under Bankruptcy Code §1182(1)(B)(iii). An “affiliate,” under the Code, includes an “entity that directly or indirectly owns, controls, or holds with power to vote, 20 percent or more of the outstanding voting securities of the debtor.” 11 U.S.C. §101(2)(A). In this case, Steelcase, a public company (by definition, an “issuer” under the Securities Act), owns 27% of debtor Serendipity’s voting securities, rendering the debtor ineligible for Subchapter V treatment. The debtor argued the relevant percentage was 6.51%—the percentage of Steelcase’s shares authorized to vote on debtor’s bankruptcy. The court rejected this, holding under the plain meaning of the statute, “An entity that owns 20% or more of the voting securities of a chapter 11 debtor is an affiliate of the debtor, whether or not it has the power to vote those securities” (quoting In re Interlink Home Health Care, 283 B.R. 429, 439 (Bankr. N.D. Tex. 2002)).
In light of cases like Serendipity, some are concerned the definition of “issuer” and “security” in 15 U.S.C. 78c(a)(8), (10) could be construed broadly enough to include member and partnership interests in LLCs, LLPs, and other forms of business organization, excluding many of these from Subchapter V.
In another case dealing with eligibility, the court in In re Blanchard, 2020 Bankr. LEXIS 1909 *6-7 (E.D. La. July 16, 2020) found the statute’s definition of a debtor as a person “engaged in commercial or business activities” did not require the business to be operating at the time of the bankruptcy.
Consensual and Non-Consensual Plans
Although Subchapter V plans can be confirmed over objections, there are significant differences between consensual and non-consensual plans. Under a consensual plan, the Subchapter V Trustee’s tenure terminates when the debtor makes its first payments, and the debtor is discharged on the effective date of the plan. In re Olson, 2020 Bankr. LEXIS 2439, *12 (Bankr. D. Utah, Sept. 16, 2020). Also, default provisions for the plan are normally negotiated with the consenting creditors. In re Pearl Res., 2020 Bankr. LEXIS 2683, *17-19 (S.D. Tex. Sept. 30, 2020). In a non-consensual Subchapter V “cramdown,” the Trustee remains in office, payments for the three- or five-year term of the plan are made through the trustee, there is no discharge until all payments are made, and the default provisions ordered by the court “may include the liquidation of nonexempt assets, to protect the holders of claims or interests in the event that the payments are not made.” 11 U.S.C. §1191(c)(3)(B).
Non-Consensual Cramdown Under Subchapter V
The Pearl case provides an extensive analysis of the requirements to cram down a Subchapter V plan over objecting creditors. Subchapter V permits confirmation of a plan without meeting three requirements for confirmation of conventional Chapter 11 cases: securing the votes of all impaired creditors, §1129(a)(8); obtaining the votes of at least one impaired class to cram down a plan, §1129(a)(10); and replacing and broadening the provisions of §1129(a)(15) regarding use of disposable income.
In place of those provisions, §1191(b) permits confirmation of a plan if the plan “does not discriminate unfairly against any impaired, non-consenting class and is fair and equitable regarding each class of impaired claims or interests that has rejected the plan.” Pearl, 2020 Bankr. LEXIS 2683 at *28-29.
For secured creditors, “fair and equitable” incorporates the same three permissible options for treatment of creditors under conventional Chapter 11 cases. Section 1129(b)(2)(A): See P. Janovsky, Dirt for Debt in Bankruptcy Plans of Reorganization, NYLJ (Oct. 11, 2019) (Dirt for Debt) (explaining options). For all creditors, Subchapter V adds a “disposable income” requirement present only for individual debtors in other Chapter 11 cases, requiring either (1) all of the projected disposable income of the debtor during the plan period will be applied to make payments under the plan; or (2) the value of the property distributed under the plan is not less than the debtor’s disposable income. 11 U.S.C. §1191(c)(2). “Disposable income” is defined as income not reasonably necessary, (1) for the maintenance or support of individual debtors or their dependents; and (2) for businesses, it includes income not reasonably necessary for the continuation, preservation, or operation of the debtor’s business. 11 U.S.C. §1191(d).
Subchapter V also contains its own definition of feasibility, requiring the plan to show the debtor will be able to make all payments under the plan, or there is a “reasonable likelihood” it will be able to do so. 11 U.S.C. §1191(c) (3)(A).
In Pearl, the debtor’s assets were leasehold interests for certain oil and gas interests, encumbered by liens of certain secured creditors. The plan provided for:
- Release of the liens on certain of the leased collateral to enable the debtor to develop and generate income from the property to fund the plan;
- Retained liens on other collateral;
- Default provisions including a springing lien on the property released and required sale of other collateral to pay claims in full.
Id. at 7-9.
The debtor’s witness provided unrebutted testimony that the projected income from the leases if the liens were released was sufficient to pay all claims, and the value of the collateral subject to the retained liens had an equity cushion equal to six times the claims. Id. at *15-16. Based on this and other evidence, the court found the plan met the disposable income test under §1191(c)(2) (A). Id. The same evidence supported the feasibility and appropriate remedies tests of §1191(c) (3). Id. at *70-74.
The final hurdle was whether secured creditors’ treatment satisfied one of the three options under §1129(b)(2). The secured creditors argued that because one of their liens was released, their equity cushion was decreased from a 29 to 1 value-to-debt cushion to a 6 to 1 cushion. But the court found they received the “indubitable equivalent” of their claims through the new cushion and the plan’s default remedies. The court cited the recent Fourth Circuit case, In re Bate Land & Timber, 877 F.3d 188 (4th Cir. 2017), approving confirmation of a plan in which release of part of a creditor’s collateral could nonetheless be the “indubitable equivalent” of the creditor’s claim. Pearl, 2020 Bankr. LEXIS 2683 at *79-80. See Dirt for Debt; see also In re Ellingsworth Residential Community Association, 2020 Bankr. LEXIS 2897 (Bankr. M.D. Fla. Oct. 16, 2020) (confirming homeowner association plan over an objection, but permitting objector to return to court if debtor did not approve an assessment to fund the plan within a reasonable time after confirmation). Bankruptcy courts appear to be guiding small businesses through the expedited process while carefully considering creditor objections, and the statute has potential to bring matters to a head quickly and with less cost than traditional Chapter 11 cases. Courts should consider adopting proposed uniform rules, and Congress should approve amendments to clarify matters like the “issuer affiliate” question discussed above.
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Reprinted with permission from the January 19, 2021 edition of the NEW YORK LAW JOURNAL © 2021 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For information, contact 877-256-2472 or firstname.lastname@example.org. # NYLJ-01202021-473046
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Peter Janovsky is a partner at ZEK and a member of both its Litigation and Bankruptcy groups. His 32 years of experience includes successfully litigating trials, motions and appeals in complex real estate, secured lending, title, partnership agreements, license agreements and many other issues in Courts on all levels.