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Companies Stretch Limits of Small Business Bankruptcy Eligibility

June 10, 2022, 10:30 AM

Bankrupt companies are testing the boundaries of a relatively new form of Chapter 11 filing formed to streamline restructuring for small businesses, spotlighting the law’s loopholes on who’s eligible for it.

Debtors filing bankruptcy under Subchapter V of the bankruptcy code, enacted by Congress in February 2020, get access to certain benefits not available in an ordinary Chapter 11. Those include debtors’ being able to keep equity and not having to deal with official creditor committees.

The attractive features intended to streamline restructuring for small business owners have led to bigger companies exploiting loopholes, such as using subsidiaries to get around a debt limit requirement. And instances of alleged misuse or abuse of Subchapter V have been piling up since the law was enacted.

Lear Capital, Infowars, Regus’ RGN-Group, and Greylock Capital Management are among the companies that have had to defend their qualifications under Subchapter V.

“Congress created Subchapter V, and no good deed goes unpunished,” said bankruptcy attorney Jennifer Raviele of Kelley Drye & Warren LLP.

In March 2020 Congress increased the debt limit to qualify for the subchapter from $2.7 million to $7.5 million as part of the CARES Act, which provided relief during the pandemic.

The expanded threshold expired in March. Both chambers of Congress have passed a bill that restores the $7.5 million limit for a two-year period, and President Joe Biden is expected to sign it.

Raising the debt threshold could entice more small businesses to seek Subchapter V. But the eligibility issue and who’s abusing its intentions could continue to flare up in bankruptcy courts.

Over the past two years, more than 3,400 struggling small companies have filed for Subchapter V relief, instead of going through a traditional Chapter 11.

Fresh Start

The American Bankruptcy Institute has supported the debt limit increase, calling it a vehicle to provide a “fresh financial start” for struggling small businesses.

“Most people are pretty pleased with the higher limits that allow more debtors to take advantage” of the subchapter, said Monique Almy of Crowell & Moring LLP. Almy serves as a bankruptcy trustee, including in Subchapter V cases.

But others say the higher limit opens the door for more abuse.

“When you expand the debt limit to $7.5 million or $10 million you bring in debtors who don’t fit the mom-and-pop intent,” said Ivan Gold of Allen Matkins LLP. Gold often represents commercial landlords in Chapter 11 cases.

One of debtors’ key advantages in Subchapter V is their dealings with creditors.

The burden of uncovering debtor fraud or abuse of the subchapter falls on individual creditors, since there isn’t a creditors’ committee appointed in these cases, said bankruptcy attorney and Subchapter V trustee Mark Sharf.

In a typical Chapter 11, debtors pay for official creditor committees’ expenses. In Subchapter V, individual creditors are left to raise challenges —including whether the debtor is a properly qualified small business—at their own expense. That could drive debtors’ motivation to push the limits on who’s eligible.

Taking Advantage

Subchapter V debtors have been creative in their use of subsidiaries and affiliates to get under the debt limit. Companies seeking to file Subchapter V not only have to meet the debt threshold, but also must be an entity that conducts business and hasn’t issued securities.

RGN-Group Holdings, a unit of work-space provider Regus, was one of the companies that had to defend its Subchapter V eligibility. Its ultimate parent is IWG International Workplace Group, a publicly traded Luxembourg corporation with “a thousand special purpose entities,” Gold said.

It’s the “most dramatic” example of Subchapter V abuse, he said.

RGN-Group, which owned furniture used in thousands of Regus work spaces in North America, had debts of more than $100 million owed to other affiliates within the IWG family. But such obligations aren’t counted in the debtor’s debt load in calculating Subchapter V eligibility.

“That is the Achilles Heel, the loophole in the statute,” Gold said.

After a Delaware bankruptcy judge questioned its Subchapter V designation, RGN-Group agreed to redesignate itself as an ordinary Chapter 11 debtor.

Greylock Capital Management LLC also tried to take advantage of the law last year but elected to dismiss an affiliate’s Subchapter V case after the US Trustee, the Justice Department’s bankruptcy watchdog, challenged the multi-million dollar hedge fund’s filing. The company struck a deal with creditors following that objection.

The law has also invited companies facing active litigation, like right-wing conspiracy site Infowars, to seek streamlined relief from their litigating creditors. In that case, Infowars owner Alex Jones tried to force a settlement with Sandy Hook school shooting victim families by putting three non-operating affiliates in Subchapter V.

A Texas court and Connecticut court independently found that Jones and his affiliate companies were liable for damages from Jones’ false statements that the killings never occurred. Those cases were halted before damage amounts were assessed.

Gold and silver coin dealer Lear Capital Inc. filed Subchapter V to head off legal claims that haven’t yet been filed. Lear’s March filing said it intended to use the process to deal with claims it could face for allegedly misleading elderly customers about buying its coins and associated fees.

Lear Capital’s filing drew scorn from 24 state attorneys general who have been investigating the company’s business practices. The AGs have asked the US Bankruptcy Court for the District of Delaware to dismiss the case for being filed in bad faith. In an unusual step, Lear agreed to let a group of customers form a committee to represent the interests of potentially thousands of deceived customers.

“This case looks a lot like a mass tort case that’s masquerading as a Subchapter V case,” customer attorney Christopher Samis of Potter Anderson & Corroon LLP said at a hearing last month.

Curbing Abuse

Congress could curb Subchapter V misuse by including debt owed to affiliates as part of the debtor’s total debt, according to Gold.

Lawmakers also could tighten restrictions by barring a company that has an affiliate that issued securities, Gold said.

Perhaps the subchapter could be available only to companies owned by one person or one family, said Sharf, adding that he wasn’t recommending it.

Without clearer limitations on eligibility, skilled lawyers will continue to try to take advantage of Subchapter V provisions, Sharf said.

“The reduced creditor protections are going to be enticing to anyone out there,” Raviele said.

To contact the reporter on this story: Daniel Gill in Washington at dgill@bloomberglaw.com

To contact the editor responsible for this story: Roger Yu at ryu@bloomberglaw.com