Welcome

Covid-19 Skews Payouts to Creditors of Bankrupt Small Businesses

Feb. 19, 2021, 11:02 AM

The coronavirus is making it nearly impossible for bankrupt small businesses to predict their future income, adding a surprise wrinkle to a recently enacted law that aims to streamline small debtors’ reorganization.

Subchapter V of Chapter 11 created a new process under which a small business with less than $7.5 million in debt can restructure in bankruptcy. Under the law, debtors can pay off creditors over a three- to five-year period under a payment plan based on “projected disposable income.” That figure should have been a routine determination based on past business performance.

Then the pandemic hit.

Covid-19-fueled uncertainty has driven debtors to lowball their projections, while court-appointed trustees have fought to boost creditor recovery. That conflict has become the focal point of bankruptcy cases for small businesses seeking to reorganize under Subchapter V.

“Projecting future income is always a trick and the pandemic has made that trick trickier,” said Donald L. Swanson, a bankruptcy attorney at Koley Jessen in Omaha, Neb.

The coronavirus has given Subchapter V debtors the latitude to deviate substantially from their pre-Covid track record when estimating future income, said Amy E. Vulpio, a partner and member of the financial restructuring and bankruptcy group at White & Williams in Philadelphia.

“Covid gives the basis to say that, ‘oh, we’re just going to arbitrarily project that our income is going to be 50%,’” she said.

Streamlined Chapter 11

Part of the Small Business Reorganization Act of 2019, Subchapter V aimed to make bankruptcy cheaper, easier, and faster for small business debtors by eliminating many requirements of a typical Chapter 11 case.

The law waives the “absolute priority rule” that requires secured creditors get paid back first and in full. Instead, it allows debtors to pay creditors back over time using disposable income, defined as what the debtor has left after “reasonable expenses” of operating the business and supporting a household.

Subchapter V also requires reorganization plans be filed within 90 days of filing bankruptcy and blocks creditors from submitting competing plans. It doesn’t require an official committee of unsecured creditors. Instead, the Justice Department’s U.S. Trustee’s Office appoints a trustee to make sure the plan is fair.

Before the law went into effect, bankrupt smaller companies usually overstated their expected income to show they could keep up with payments on secured assets in order to get their plans confirmed, Swanson said.

“Subchapter V has flipped that on its ear a little bit,” he said. Debtors with more unsecured debt—such as service-based businesses—now have an incentive to understate projected income to keep plan payments low, Swanson said.

Without a committee, the Subchapter V trustee may be the only one advocating in court for higher creditor payments in the Chapter 11 plan. Creditors have the right to intervene in a Subchapter V case, but many are small businesses themselves and often don’t have the time or resources to do so.

Lower payments aren’t all bad news for creditors, however.

For many, the real recovery “is not what you’re getting from the distribution in the plan,” said Barbra R. Parlin, an attorney at Holland & Knight LLP in New York, whose practice includes bankruptcy, restructuring, and creditors’ rights. “It’s the fact that they have an ongoing customer. That’s what’s important to them.”

“I’m happy when a debtor can reorganize,” said Cindy G. Oliver, a bankruptcy attorney at Longleaf Law Partners in Raleigh, N.C., who represents creditors in bankruptcy cases. “It’s just good for everybody.”

Sizzler Case

Sizzler USA Inc.'s recent bankruptcy case shows how the issue is playing out in the courts.

The Mission Viejo, Calif.-based restaurant chain filed for bankruptcy under Subchapter V in the U.S. Bankruptcy Court for the Northern District of California in September.

In its Chapter 11 plan, Sizzler projected future income from just 63 of 98 franchisee stores after 33 closed permanently or temporarily in response to the pandemic.

Subchapter V Trustee Mark M. Sharf objected, saying that if Sizzler in fact had 98 franchisees, future revenues would be significantly higher than what the company indicated. If business improves, the company should have to pay whatever is leftover from its actual income, rather than projected income, he said.

Sizzler can modify its plan later if business sours, but its creditors can’t step in later and ask for higher payments, Sharf said. “If things don’t go well, they’ll modify,” he said. “What if things do go well?”

Judge M. Elaine Hammond said Sharf’s argument was “compelling,” but goes against the “plain text” of the code. But she said she could change her mind later.

“While I believe this to be the correct analysis, we are still developing the case law, and as I see more of these, the analysis may expand,” the judge said.

Evolving Case Law

With fewer than 1,500 Subchapter V filings nationwide, courts’ interpretation of the disposable income rules is still evolving—often with a big coronavirus-shaped asterisk.

Chapter 13, a bankruptcy option only available to individuals, includes a similar payment plan based on projected income. Bankruptcy judges might draw on Chapter 13 to help define projected income in Subchapter V cases, but it’s too early to tell, attorneys say.

Courts will have to determine the fairness of income projections on a case-by-case basis because of the “fact-intensive” nature of the issue, Swanson said.

“I don’t think that problem can be resolved by rules of law,” he said.

To contact the reporter on this story: Leslie A. Pappas in Wilmington, Del. at lpappas@bloomberglaw.com

To contact the editors responsible for this story: Laura D. Francis at lfrancis@bloomberglaw.com; Roger Yu at ryu@bloomberglaw.com

To read more articles log in.

Learn more about a Bloomberg Law subscription.