May 02, 2019

Chapter 11 for Small Businesses

8 min

Chapter 11 of the United States Bankruptcy Code is a useful tool available to businesses (and even some high-net-worth individuals) to restructure their debt, shed their liabilities, and reorganize. Chapter 11 is also used by companies to sell all or substantially all of their assets "free and clear" of liens, claims, and interests relatively quickly. Buyers recognize the value of being able to acquire assets free and clear pursuant to 11 U.S.C. § 363 (referred to as "Section 363 Sales") and of the Bankruptcy Court's ability to establish certain sale and bidding procedures that enable sales to close relatively quickly. Most sale orders afford valuable protections to buyers including the removal of liens, the imposition of injunctions that prohibit creditors from pursuing claims against the buyer, good faith purchaser findings that protect buyers from having to wait until all appeals are resolved before closing the sale, and in some cases, findings of no successor liability. The ability of a company to conduct an orderly sale in Chapter 11 while maintaining the going concern value of the business is attractive to buyers, sellers, and creditors.

However, the cost to successfully reorganize in Chapter 11 has remained a significant hurdle for small businesses. According to recent statistics released by the Administrative Office of the U.S. Courts, U.S. bankruptcy filings fell by nearly 1 percent for the 12-month period ending March 31, 2019, compared with a year earlier. Of this number, approximately 5,852 Chapter 11 business bankruptcy cases were filed nationwide, with the vast majority being filed in either the District of Delaware or the Southern District of New York. This data continues a national trend of declining business bankruptcy filings since 2011, with certain notable exceptions, including the retail, oil and gas, and media and entertainment sectors. It is no surprise that perhaps the greatest hurdle for companies that want to file Chapter 11 are the legal fees and costs incurred in confirming a Chapter 11 plan and emerging from bankruptcy. Chapter 11 cases take a lot more time than other bankruptcy cases, and require extensive pre-bankruptcy planning with the assistance of retained professionals, including bankruptcy attorneys, financial advisors, investment bankers, and others. Chapter 11 usually involves extensive negotiations with creditors and other parties in interest (including an Official Committee of Unsecured Creditors), the drafting of complex "First Day" motions, preparation and attendance at the initial debtor interview with the U.S. Trustee's Office, meeting of creditors, and numerous hearings, the preparation and filing of a Disclosure Statement and Chapter 11 Plan, and yet more negotiation to confirm a Chapter 11 Plan. While the commencement of a bankruptcy stays most litigation, larger Chapter 11 cases are often contentious and involve extensive law and motion practice and mini-lawsuits called "adversary proceedings." It is no surprise that because of the steep costs of reorganization under Chapter 11, large private and public companies are more likely to avail themselves of this powerful reorganizing tool. To minimize the costs of remaining in Chapter 11 too long, many recent filings involve pre-negotiated, pre-arranged, or pre-packaged Chapter 11 plans.

Given these hurdles, many small businesses and middle-market companies have chosen to restructure their debt obligations out of court or to liquidate rather than to incur the legal and operational costs of reorganizing in Chapter 11. However, last month, the Senate Judiciary Committee reintroduced the Small Business Reorganization Act, Senate Bill 1091 (SBRA), under which a new subchapter V would be added to Chapter 11 of the Bankruptcy Code. Attached is a copy of the proposed Act in its current form, and a fact sheet published by the Senate Judicial Committee. This new subchapter would provide small businesses (companies including sole proprietorships with non-contingent, liquidated debts in an amount not greater than $2,566,050) with an opportunity to restructure their liabilities through a streamlined and cost effective Chapter 11 bankruptcy process. The SBRA also offers small business owners the opportunity to retain their ownership interest in the reorganized company. This is beneficial when compared to the current version of Chapter 11, which generally results in the cancellation of equity, unless equity holders provide new value to fund a Chapter 11 plan of reorganization or the Chapter 11 plan provides for payment in full to all unsecured creditors. The SBRA is also favorable when compared to receivership proceedings or Assignments for the Benefit of Creditors, which are tools for liquidating a company.

If the SBRA passes, small businesses will be able to successfully emerge from bankruptcy with a Court-approved plan of reorganization that must be filed not later than 90 days of a bankruptcy filing. The benefits offered to businesses that file Chapter 11 bankruptcies, including a debtor's ability to right-size its balance sheet, reduce liabilities, reject or restructure burdensome leases and executory contracts, renegotiate funded debt, and sell its assets, will now be available for smaller companies without having to incur the costs associated with larger Chapter 11 filings.

Key features include the following:

"Small Business Debtor" Defined

Although the Senate Bill does not define a "small business debtor," the Bankruptcy Code defines a small business debtor as:

  • ". . . a person [defined as an individual partnership, and corporation] engaged in commercial or business activities (including any affiliate of such person that is also a debtor . . . excluding a person whose primary activity is the business of owning or operating real property or activities incidental thereto) that has aggregate noncontingent liquidated secured and unsecured debts as of the date of the filing of the petition or the date of the order for relief in an amount not more than $2,566,050 (excluding debts owed to 1 or more affiliates or insiders). . ." ; and
  • "does not include any member of a group of affiliated debtors that has aggregate noncontingent liquidated secured and unsecured debts in an amount greater than $2,566,050 (excluding debt owed to 1 or more affiliates or insiders)."

11 U.S.C. § 101(51D) (emphasis added).

Chapter 11 Debtor as Exclusive Plan Proponent

Unlike the current version of the Bankruptcy Code, which allows any party-in-interest to file a Chapter 11 plan once the debtor's "exclusivity period" has expired, the SBRA only authorizes the small business debtor to file a Chapter 11 plan of reorganization.

Streamlined Process to File and Confirm Chapter 11 Plan

The SBRA imposes the following truncated timeline to file a Chapter 11 plan of reorganization, significantly reducing administrative expenses in bankruptcy:

  • Not later than 60 days after the bankruptcy filing, the Bankruptcy Court will hold a status conference "to further the expeditious and economical resolution of a case under this subchapter."
  • Not later than 14 days before the status conference, the debtor's bankruptcy counsel is required to file a report that details the steps the company and its advisors have taken to attain a consensual plan of reorganization.
  • Unless the debtor requests an extension related to circumstances outside of its control, the Chapter 11 plan of reorganization must be filed not later than 90 days after the bankruptcy case is filed.
  • Once the debtor completes all payments according to the plan, the reorganized debtor will receive a discharge from all of its pre-confirmation debts.
Chapter 11 Plan Requirements

The Chapter 11 plan of reorganization must provide the following:

  • All projected disposable income of the debtor to be received within a 3-5-year period (i.e., 3 years "or such longer period not to exceed 5 years as the court may fix"), beginning on the date that the first payment is due under the plan, will be applied to make payments under the plan; or
  • The value of property to be distributed under the 3-5-year plan, beginning on the date on which the first distribution is due, is not less than the projected disposable income of the debtor.
Continued Ownership and Management

The Chapter 11 plan may permit the owners of the small business debtor to retain their stake in the reorganized debtor, as long as the plan does not discriminate unfairly, and is "fair and equitable," with respect to each class of claims and interests.

  • A debtor may satisfy the fair and equitable requirement in one of the following ways:
    • The debtor's advisors must identify the debtor's "disposable income," and the plan of reorganization must explain how the disposable income will be distributed to the standing trustee during a 3-5-year period in order to effectuate payments to creditors under the plan; or
    • The plan may require the debtor to distribute some or all of its property to the standing trustee for the benefit of its creditors, provided that such property "is not less than the projected disposable income of the debtor" during the 3-5-year period.
  • The debtor's management will continue to operate the business, but may be removed for fraud, dishonesty, incompetence, or gross mismanagement.
Plan Modifications

The Chapter 11 plan may be modified by the reorganized debtor upon a showing of changed circumstances, after notice and a hearing.

Appointment of a "Standing Trustee"

A "standing trustee" will be appointed and will remain throughout the payment period set forth in a confirmed Chapter 11 plan to account for all of the property received by the debtor, examine and object to the allowance of claims, review the debtor's financial condition and business operations, report fraud or misconduct, appear at hearings, prepare a final report and account, help facilitate a plan of reorganization, distribute property in accordance with a confirmed plan, and ensure a debtor's compliance with the confirmed plan. The Chapter 11 trustee's role is similar to that of a Chapter 13 trustee applicable to individual debtors.

No Official Committee of Unsecured Creditors

An official committee of unsecured creditors will not be appointed unless the Bankruptcy Court for cause orders otherwise. This reduces the administrative burden on the small business debtor of having to pay fees and expenses incurred by committee professionals.

Employment of Estate Professionals

Unlike the current version of the Bankruptcy Code, which disqualifies professional persons from being employed if they hold a pre-petition claim against the bankruptcy estate, the SBRA provides that professional persons are not disqualified from employment by a small business debtor if the professional is owed less than $10,000 prior to the date of the bankruptcy filing.

Although Congress has not yet passed the SBRA, the bill has bipartisan support and has been developed with the input of the American Bankruptcy Institute, the National Conference of Bankruptcy Judges, and other organizations.

Please contact Keith Owens if you have any questions.