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INSIGHT: Small Businesses Get Break From Chapter 11 Burdens

March 5, 2020, 9:01 AM

Chapter 11 bankruptcy allows companies to survive through tough financial times. It provides breathing room for debtors to negotiate with creditors and propose a reorganization plan to pay those creditors. However, for small businesses, which make up 99% of all businesses in the U.S., the advantages are outweighed by substantial disadvantages.

For small businesses, Chapter 11 bankruptcy is costly, time-consuming, has burdensome procedural and reporting requirements, and is risky for owners who wish to retain their ownership interests in the company.

In particular, creditors have a distinct advantage because a certain number of creditors must vote to accept a reorganization plan in order for that plan to be approved by the court. For that reason, many attorneys are hesitant to recommend filing a Chapter 11 bankruptcy for a small business.

The Small Business Reorganization Act of 2019, which took effect Feb. 19, shifts much of the leverage to debtors and makes a successful Chapter 11 reorganization more of a possibility.

The act implements a new subchapter of Chapter 11 (Subchapter V) called a “Small Business Debtor Reorganization,” which is available to debtors that have no more than $2,725,625 of secured and unsecured debt. It is available to both companies and individuals whose debts primarily arose from commercial or business activities.

Act’s Advantages

Some of the main advantages to debtors under the act include:

  • Streamlined procedures meant to make the process more efficient, economical, and less burdensome to the debtor;
  • The exclusive right to file a plan;
  • Generally, no creditors’ committee;
  • Generally, no requirement of filing a disclosure statement;
  • The elimination of the “absolute priority rule,” which made it difficult for business owners to retain their ownership interests;
  • The ability to confirm a reorganization plan, even if no creditors vote to accept the plan; and
  • For individuals who file a Subchapter V bankruptcy, the ability to modify certain residential mortgages, if the underlying loan was not used to acquire the residence and was primarily used in connection with the small business.

The act creates a new tool that bankruptcy attorneys did not have previously. Businesses that would have previously had to liquidate now may have a new chance to survive. Importantly, the leverage and landscape have changed. Approximately half of all Chapter 11 debtors will now be able to take advantage of the act, given the debt limitation.

Should Your Small Business Client File Under Chapter 11?

Attorneys must be mindful of a few important points in considering whether to recommend that a company or individual take advantage of the benefits of the act.

1. Evaluate Whether the Business Can Survive
Bankruptcy cannot solve all problems. The act is meant to help companies that are able to remain cash flow positive after the elimination or reduction of certain debts. If a company is dead on arrival, unable to sustain itself even after reorganizing its debts, it is not a good Chapter 11 candidate. In that instance, it would be appropriate to discuss liquidation options.

2. Be Mindful of the Company’s Cash Flow
Assuming that the business can survive, it is extremely important to develop a budget early on, which takes into account how the company’s cash flow will look post-bankruptcy.

In order to confirm a reorganization plan under Subchapter V, a company may be required to devote all of its projected disposable income in a period of time ranging from three to five years to payments under the plan (or the value of the property to be distributed must not be less than the projected disposable income).

In addition, there is a trustee appointed in every Subchapter V case, whose role includes facilitating the development of a consensual reorganization plan. The company must ensure that it has positive cash flow, sufficient not only to pay ongoing operating expenses, but administrative expenses.

3. Get the Company’s Financial Statements Prepared Before Filing
The good news is that a Subchapter V bankruptcy is a fast and streamlined process. However, for a company whose financial statements are in disarray (which is not uncommon for small businesses), this can prove to be a negative. Certain reports must be filed shortly after the bankruptcy filing. The company must ensure that its books and records are good working order. A company with inaccurate financial statements will find itself exiting bankruptcy (or worse) if it does not properly prepare.

4. Don’t Forget That Individuals Can File a Subchapter V Bankruptcy
Oftentimes, a small business owner will personally guarantee many of the debts of the company. A corporate bankruptcy alone, in most instances, will not eliminate these personal guarantees owed by the individual(s). Other times, the business is simply owned as a sole proprietorship.

It’s important to remember that Subchapter V is available to individuals, too. Prior to the act, an individual considering bankruptcy had to choose between a Chapter 7 liquidation, Chapter 13 reorganization, or an individual Chapter 11 (which contains the same onerous requirements as a corporate Chapter 11).

Now, however, an additional option is available to individuals under the act. It is important to recognize the pros and cons of each procedure and choose the best option for the individual. It is important for small business debtors to have experienced counsel that can navigate this new law and bring about a successful reorganization.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Zach Shelomith is a member of Leiderman Shelomith Alexander + Somodevilla PLLC in Fort Lauderdale, Fla. He is board certified in business bankruptcy law and consumer bankruptcy law by the American Board of Certification and represents numerous small business debtors in Chapter 11 bankruptcy proceedings.