If you run a small business and the debt has gotten out of hand, you might be wondering whether you can preserve your business if you file bankruptcy.
Prior to February 2020, the only way to save a struggling business through a bankruptcy was through the traditional Chapter 11. But Chapter 11 was often financially out-of-reach for small businesses because Chapter 11 debtors were required to pay for their own attorneys and the lawyers for the unsecured creditors’ committee, along with quarterly U.S. Trustee fees. One estimate put the cost of a Chapter 11 case at 1% to 5% of the debtor’s total assets.
Back in the old days, if you owned a business that filed Chapter 11, you had 120 days to come up with a plan of reorganization and 180 days to convince the court that your plan should be confirmed. The court could extend those deadlines if it wanted. If you didn’t file a plan and get it confirmed within those time limits, anyone “in interest” could file their own plan. Once you filed your plan, to get it confirmed at least one “impaired class” has to vote for it. That means owners were involved in a negotiation with each class involved in the case for months. If the owners wanted to do anything outside the ordinary course of business — sell assets, pay off debt, borrow money, hire new officers — that had to be approved by the court, usually after a briefing and a hearing, all of which was paid for by the debtor.
Other options, like a liquidation under Chapter 7 or an assignment for the benefit of creditors under state law, meant shutting down the business for good. The debtor would assign its assets to an “assignee”, usually an attorney or accountant, to collect, sell and distribute the assets to the creditors according to priority. (Or the assignee could run the business for 45 days or longer with court permission.) The objective here was a dissolved company.
Subchapter V of Chapter 11
Subchapter V of Chapter 11 is a provision of bankruptcy law, created in the Small Business Reorganization Act, that went into effect on February 19th, 2020. In Subchapter V, the debtor proposes a repayment plan, and if the plan is approved, can reorganize with the ability to make payments to their creditors over a period of three to five years while continuing to operate. There’s no liquidation. Before the COVID crisis, the maximum debt for Subchapter V of Chapter 11 was $2,725,625. This debt limit was raised to $7.5 million during the pandemic and that amount was made permanent in June 2022.
Can You Keep Your Business
So can you keep your business? The short answer is yes, and the reason is a single rule that Subchapter V leaves out: the “absolute priority rule.” Chapter 11 has the absolute priority rule which means lower-priority creditors don’t get anything until the higher-priority ones are paid in full. For practical purposes, the absolute priority rule mandates that creditors are entitled to repayment of their debts in full before equity interest holders can receive any return on their investment. In a regular case, often the result is that the owners (who are “equity holders”) lose everything if the creditors are not paid in full. Owners can avoid that only if they contribute “new value” – usually a big cash infusion – into the company.
Under Subchapter V, the absolute priority rule does not apply. Owners can retain their ownership stakes without providing any “new value,” even if their creditors are not paid in full.
There is a cost. Every dollar of the projected disposable income over the 3-5 year plan period goes to the creditors, who also must receive at least what they would have received in a liquidation.
Remember the vote from an impaired class? That requirement does not exist in Subchapter V. That means the court can “cramdown” your plan over creditor objections, as long as all your projected disposable income goes to creditors and secured creditors keep the benefit of their collateral. Only your company (the debtor) can propose a reorganization plan, and it must be filed within 90 days of filing, unless the court grants an extension for cause. The new law also appoints a Subchapter V trustee, who gets your future income to the extent needed to carry out the plan. The result should be relatively quick cases.
None of this means your creditors are left with nothing. What your creditors do get in return is that you commit to pay all of your projected disposable income over the life of the plan (up to 5 years). And they still get at least what they would receive in a liquidation. The trustee is an extra measure of protection – an additional layer of security that the plan gets carried out. In a standard Chapter 11 case a plan is often offered that pays unsecured creditors significantly less than their claims. The only test is that it beats liquidation. Your creditors may not be happy, but the deal isn’t one-sided.
Subchapter V is much cheaper. Without the need for a committee of unsecured creditors, Subchapter V debtors don’t have to pay the professionals hired by that committee and can avoid quarterly fees owed to the U.S. Trustee. In addition, the debtor’s professionals, including lawyers, can be paid over the course of the plan instead of upfront. Of course, you will still need court approval to do things outside the ordinary course of business, like selling assets, paying some debts, getting a loan or hiring new officers.
Switch to Subchapter V
But debtors who start a regular Chapter 11 and switch to Subchapter V? Courts have allowed it when it is proposed soon after the case begins. Owners and businesses that start in Chapter 11 and try to shift to Subchapter V later may not be able to, as the Judge in the Seven Stars on the Hudson bankruptcy case determined. In that case, the debtor’s case had been pending for over a year, and at that point there were a bunch of significant problems that would make it very tough to switch. Switching would have put the debtor in immediate default of one of the key deadlines (filing a plan), that debtors in a Subchapter V have, and the court had already ruled on key issues (approval of a settlement with a creditor, cash collateral agreement with the bank, a ruling on post-petition rent). So the court found that the case was too far along to go backward. Don’t dawdle.
So, can you keep your business in Subchapter V? If your debts fall under the limit and the business can support a plan, the answer is yes. On the plus side, it is much cheaper than Chapter 11, and owners can retain their ownership stake without putting any money into the company. The price is that you have to give your creditors essentially all the money you can over 3-5 years. For an owner whose other choice is closing the doors, that trade deserves a hard look.
