For owners of small businesses, Chapter 11 of the U.S. Bankruptcy Code can be a complex and costly burden. For many small businesses, Chapter 11 is too complex and the debtor typically gets overwhelmed with papers and impossible demands while fighting to reorganize the business and become profitable again. The normal process of filing for Chapter 11 takes a lot of time, energy, and money. Subchapter V of Chapter 11 was created to provide a simplified and more streamlined process for small businesses to reorganize their debts and continue operating. It was enacted as part of the Small Business Reorganization Act of 2019 and became effective on February 19, 2020. If a business doesn’t have the money to pay back its debts, it can choose to renegotiate those debts instead of laying down and going under. For an owner buried in debt, the real question is what happens to each kind of debt once the case is filed.
Not every business qualifies, and for a company the main test is a debt cap. If a business has more than $7.5 million in qualifying debt, it is unable to file for Subchapter V. Check the current limit with an attorney. You can’t count debt that isn’t fixed or you only might have to pay. Debts to the owner or other related companies, for example, are not counted. Debts of affiliates that are also in bankruptcy are added together. In the case of an individual owner, at least half of the total must be business-related. To use Subchapter V, you must file a petition asking to use that section.
There Is No Absolute Priority Rule in Subchapter V
The biggest change is for unsecured debt: vendors, credit cards and similar creditors. A regular Chapter 11 case runs on the absolute priority rule. What it means is that if the unsecured creditors are not paid in full, the debtor’s owners cannot retain any interest in the reorganized company. That means if you owe more than you can afford to pay unsecured creditors you have to give the company up. That is not the case in a Subchapter V. There is no absolute priority rule in Subchapter V. Basically it means the reorganization can go through and pay creditors less than in full, but the owners can still keep their ownership interest.
What unsecured creditors receive instead is tied to the business’s “projected disposable income.” In plain English, that’s the debtor’s income minus the expenses it actually needs to pay in the future for its business and family. And the debtor makes payments on unsecured claims out of that “projected disposable income.” A plan of reorganization can be confirmed despite objections by a dissenting class of unsecured claims if the plan provides that all of the business’s “projected disposable income” will be paid to creditors. That income is measured over three to five years, and not all of your creditors need to agree to the plan for you to complete your reorganization.
Speed helps too. A Chapter 11 case can get bogged down with delays as parties argue over a plethora of filings. In Subchapter V only the business may file a plan. A Subchapter V debtor has to propose a plan within 90 days of the petition date, unless the court extends the deadline. With Subchapter V you are still expected to keep trying to run your business and make money. It is cheaper as well. Subchapter V business debtors usually do not have to face a creditor’s committee in their Chapter 11. A regular case often has a committee of unsecured creditors. That’s a lot of people to organize, it’s time-consuming to get a committee working together, and it’s expensive. There are no quarterly fees to the U.S. Trustee, and a disclosure statement is the exception rather than the rule.
Secured lenders fare better. The cramdown rules for secured claims are the same as in a regular Chapter 11, and a lender can still make a Section 1111(b) election, which can sometimes block a plan by making its payments unaffordable. There’s only so much that you can do in Subchapter V on this issue.
When Does the Debt Go Away
When does the debt go away? The answer depends on how the plan gets confirmed. If the creditors reject the plan, the business can either change the plan to make it acceptable, or the court can confirm the plan anyway under the Subchapter V test. In that case, it depends on your ability to make payments on the Subchapter V reorganization plan, because the business will not receive a discharge until all plan payments are made. Once it successfully repays the plan, and the court grants a discharge, the debt is extinguished. The trustee usually collects those payments and distributes them, and the plan must give creditors remedies if payments stop.
That trustee is appointed in every case by the U.S. Trustee’s office, which sounds worse than it is. You are still your own boss. In Subchapter V, the bankruptcy debtor will remain in control of the business. The trustee’s role is more supervisory than operational. Until a plan is in place, the trustee is closer to a mediator. They will work with the debtor and any creditors to help reach a plan. A trustee can be ordered to investigate, however, and if that turns up fraud, dishonesty or mismanagement, the court can remove the owners and put the trustee in charge.
Then there is the personal guarantee. A personal guarantee is when a business owner signs a personal pledge, which says they promise to pay back a business loan. Think of it like a co-signer, but it’s the owner guaranteeing their own business’ debt. The problem with personal guarantees is that your personal assets are now at stake. When the company files bankruptcy under any chapter of the Bankruptcy Code, that does not change the fact that you have personally guaranteed the company’s line of credit. Some owners respond with a Subchapter V case of their own, paying guarantee claims less than in full out of their disposable income, ideally before the company files.
Subchapter V Is Not the Only Option
Subchapter V is not the only option. An out-of-court workout is an informal agreement between the debtor and its creditors. The debtor voluntarily offers the creditors some incentive, usually a reduction of the amount owed or a payment plan, and asks the creditors to forgive the remainder. It works when there are relatively few creditors involved, such as the senior secured creditor, a landlord, one or two vendors, etc. There’s no automatic stay while negotiations are being made, and the more creditors there are, the trickier it gets.
Subchapter V will not be the right answer for every business. But for those that can use it, Subchapter V is a game-changer. In the end, the key issue is the ability of the business to continue to operate without being encumbered by the unpayable debt. Because there is no absolute priority rule in a Subchapter V case, the small business owner does not have to go away and disappear just because there are not enough funds to pay its unsecured creditors. Still, the decision on how to proceed to either navigate the bankruptcy process or avoid it altogether requires considerable knowledge of the laws and regulations. It’s time to talk to an experienced bankruptcy attorney who can tell you what steps are available and how to proceed.
