New Law Makes Chapter 11 Bankruptcy An Attractive Option for Small Businesses in Distress
By: Steve Jakubowski, Ariel B. Cutts
On February 19, 2020, the Small Business Reorganization Act went into effect. The purpose of the new law is to offer an alternative, more streamlined path in chapter 11 reorganizations for small business debtors (including sole proprietorships). When the new law was passed, the only small business debtors eligible to file were those having less than $2,725,625 in debt, at least 50% of which arose from business activities. The Coronavirus Stimulus Bill changed that by increasing the limit to $7.5 million. With a stroke of the pen, the new law—with its streamlined Chapter 11 procedures—is now relevant to vastly more small businesses in distress.
A primary purpose of the new law was to drop the "absolute priority rule" for small business debtors. By so doing, owners of a small business can now retain their equity or member interests even though creditors are not being paid in full under the chapter 11 reorganization plan. The tradeoff in favor of creditors is that the law requires the small business debtor to allocate its "projected disposable income" over the next 3 to 5 years to creditors who were owed money at the time of the bankruptcy filing.
One significant factor weighing in favor of a small business debtor's filing under the new law is that a creditors' committee is not formed, thereby eliminating the need for the debtor to pay not just its own lawyer, but the committee's lawyer too. However, the small business debtor's feet will be held closer to the fire as it will have only 90 days to file a reorganization plan, with very limited right to extend. The new law does treat the small business debtor like any other Chapter 11 debtor and allows it to remain in control after the bankruptcy case is filed and manage the business in the ordinary course.
Another important change in the new law is that a "standing trustee" instead of a creditors' committee is responsible for oversight of the small business debtor. The standing trustee is selected by the U.S. Department of Justice from a list of preapproved turnaround professionals. The trustee's main function is to give creditors and the court some assurance that the debtor has proposed a feasible plan that deserves creditors' acceptance. Because the standing trustee will be an independent voice, creditor skepticism should be more easily overcome and more consensual plans should be confirmed at far less cost.
The rights of secured creditors are generally unaffected by the new law compared to a typical Chapter 11 case, except that the new law allows a mortgage on a debtor's principal residence to be stripped down to the fair value of the property if the loan proceeds were used primarily in the business. By comparison, until the new law was passed, only family farmers had that right under Chapter 12 of the bankruptcy code.