April 13, 2020
Many small businesses owners who suddenly found their revenues devastated by the economic fallout from the COVID-19 pandemic have looked to the billions of dollars of low-interest loans made available by the CARES Act. While it has received far less public attention, another provision of the Act expands access to a powerful financial tool with the potential to help businesses avoid ruin and weather the storm. This tool—a Chapter 11 reorganization under the recently enacted Small Business Reorganization Act— streamlines the traditionally expensive and cumbersome Chapter 11 bankruptcy process into a more manageable and less taxing proceeding.
Small Business Challenges in Traditional Reorganizations
In a traditional Chapter 11 bankruptcy, the debtor (the business or individual that is the subject of the bankruptcy) is given a reprieve from creditors’ collection efforts. The bankruptcy filing acts as an “automatic stay” that temporarily prohibits creditors from filing or prosecuting lawsuits, executing on judgments, foreclosing liens on the debtor’s assets, or taking certain other actions that threaten the debtor’s financial stability. And, the debtor is given the opportunity to file a plan of reorganization that permanently alters the debtor’s obligations to its creditors. The plan may allow the debtor to effectively reduce the principal amount of its debt to its secured creditors down to the value of the collateral, stretch payments out over a longer period of time, reduce interest rates, and lower monthly payments. The plan may also provide for a significant reduction, restructuring, or elimination of the debt owed to unsecured creditors.
While a traditional Chapter 11 reorganization can be tremendously beneficial to a struggling business, it can also be prohibitively expensive, time-consuming, risky, and involve contested litigation to gain bankruptcy court approval of a reorganization plan. The debtor and its lawyers and financial consultants must spend substantial time to formulate the reorganization plan and an accompanying “Disclosure Statement,” documents that require technical and financial expertise and disclosures about the debtor’s past, present and future finances, management and the like. Committees may be appointed to represent the interests of creditors. These committees may hire their own lawyers and other professionals, whose fees are payable out of the debtor’s property and income. The debtor must generally obtain votes accepting its plan by at least one class of creditors, which often requires the debtor to engage in heavy negotiations. The debtor risks having a creditor or committee file and obtain confirmation of its own plan of reorganization, which is likely to be more burdensome, and which may even provide for the business’s liquidation. And, the debtor’s owners are prohibited from retaining their equity unless the plan provides for full payment of all pre-bankruptcy debt or the equity holders make a “new value contribution”—generally in the form a cash payment equal to the value of the equity retained.
In short, a traditional Chapter 11 reorganization can often be far too expensive and time consuming for many small businesses to undertake. This is where the CARES Act and the Small Business Reorganization Act (SBRA) that was passed by congress in 2019 may now provide small businesses with much needed and meaningful relief.
Relief under the SBRA
Earlier this year, before the scale of the economic and public health emergency wrought by the coronavirus became evident, the SBRA became effective. The SBRA makes it significantly more expedient and cost-effective for eligible small businesses to restructure their debts through a Chapter 11 bankruptcy reorganization. Among other benefits:
- No committees are allowed in an SBRA case unless the bankruptcy court expressly orders otherwise;
- The debtor need not obtain approval of a disclosure statement unless the bankruptcy court expressly orders otherwise;
- The debtor has the exclusive right to seek confirmation of a plan. Competing plans are not allowed;
- It is not necessary for the debtor to obtain votes approving its plan by any class of creditor. The bankruptcy court may confirm the debtor’s plan as long as it satisfies certain minimum requirements and is “fair and equitable;”
- It is also not necessary for the debtor’s owners to make a new value contribution as a condition of retaining their equity. Instead, the debtor must commit to contributing its projected disposable income (i.e., net revenues minus reasonable operating costs) for a period of 3 to 5 years toward payment of its pre-bankruptcy debts.
These provisions of the SBRA significantly improved small business access to the bankruptcy courts, but it too had its limitations. Most critically, reorganizations under the SBRA were limited to businesses and individuals with no more than $2,725,625 in debt, at least 50% of which must have arisen from the commercial or business activities of the debtor. Small businesses whose total debt exceeded this limit could only seek reorganization through a traditional Chapter 11 proceeding, with all of its attendant costs and complexity.
The CARES Act Expands Eligibility under the SBRA
The CARES Act substantially expands access to the SBRA for small businesses and individuals by temporarily increasing the debt limit from about $2.7 million to $7.5 million. This increase in the debt limit applies to bankruptcy petitions filed from March 27, 2020 through March 26, 2021. It sunsets one year from the CARES Act’s enactment.
Thus, small businesses that do not qualify for the SBA loan or other relief under the CARES Act, or who find this relief insufficient to fully recover, should know that all is not lost. If ongoing debt issues prevent stabilization or threaten viability, a small business with less than $7.5 million in debt may still later seek relief and reorganize is obligations under the streamlined and more efficient SBRA—at least until the increased debt limit sunsets on March 26, 2021.
About the Author: Bradley Pack is a shareholder with the law firm of Engelman Berger, P.C. He is a certified business bankruptcy specialist, whose practice focuses primarily on debtor-creditor relationships, workout and insolvency issues, commercial litigation, and civil appeals. [email protected] | 602.222.4994
Disclaimer: This article is not legal advice and is only for general, non-specific informational purposes. It is not intended to cover all the issues related to the topic discussed. If you have a legal matter, the specific facts that apply to you may require legal knowledge not addressed by this article. If you need legal advice, consult with a lawyer.