Perspective: The CARES Act and its Impact on Chapter 11 Reorganizations for Small Businesses
Chapter 11 reorganizations have rightly been criticized as too expensive for small and medium size businesses. On top of the cost, owners were often unable to retain their equity stakes because typically creditors either had to accept less than full payment or the equity holders had to kick in substantial sums of their own money. This past year, however, two pieces of federal legislation combined to ease the burden on small businesses, and temporarily, some not-so-small businesses.
First, Congress passed the Small Business Reorganization of Act of 2019 (the “Act”), which took effect in February 2020. The Act amended chapter 11 to make its provisions significantly less burdensome on small businesses that opt into its provisions. The Act did not change the definition of “small business,” though, which provides for a maximum debt load of $2.73 million. Thus, the amendments did not have a significant impact in major metropolitan areas, where even small businesses in financial distress typically carry debt loads above that threshold. But with the advent of the COVID-19 national emergency, Congress temporarily (until March 27, 2021) raised the debt ceiling in the definition of “small business” to $7.5 million in the CARES Act. That change makes chapter 11 accessible to a much broader set of business.
The Act’s changes to chapter 11 are significant. What typically makes chapter 11 cost prohibitive for small and medium size businesses is the cost of monitoring the reorganizing company (known as a debtor in possession) by a creditors’ committee. That is because the attorneys and financial advisers of the creditors committee are paid by the debtor in possession. In addition, the debtor in possession must pay quarterly fees to underwrite a governmental monitor. The Act eliminates both creditors’ committees and those quarterly fees for small businesses that elect the provisions of the Act. The Act also dispenses, in most cases, with the costly requirement of preparing a prospectus-like court approved disclosure statement that gets sent to creditors along with the chapter 11 plan to solicit their votes.
Besides substantially reducing costs, the Act makes it easier for owners to retain their equity interests in the business emerging from bankruptcy. Under the Act, only the debtor may propose a plan. This feature eliminates the ability of creditors to force a sale or liquidation of the business over the owners’ objections. Moreover, the Act has a special “cram down” feature that allows the owners to keep their equity when creditors refuse to accept less than full payment without having to make a substantial monetary contribution to the business from their own pockets. Instead, the reorganized business must pay its projected disposable income, essentially, the excess of revenues over ongoing business expenses for 3 to 5 years, or, alternatively, provide that the equivalent value of such excess will be distributed under the plan.
A notable feature of a small business reorganization under the Act is the role of the trustee. Most chapter 11 cases do not have a trustee. And in those that do, usually when the court finds fraud or gross mismanagement, the trustee completely displaces the business’s managers. A trustee under the Act performs a very different function, acting primarily as a disbursing agent who collects plan payments from the debtor and distributes them to the creditors. Another notable feature postpones the discharge of the debtor’s pre-bankruptcy debts until the payments under the plan are complete. The Act also comes with increased flexibility for the reorganized business. Unlike a typical reorganization, a confirmed plan for small businesses under the Act is easily modified to take into account changed circumstances. This greatly enhances the ability of a reorganized business to navigate its creditor obligations.
Another benefit of a small business reorganization under the Act is that it allows individuals engaged in most kinds of business or commercial activities to restructure certain aspects of their personal finances. For instance, they may use the plan to modify the mortgages on their personal residences if the mortgage was used to fund the business.
The combination of the Small Business Reorganization Act and the CARES Act provides a major, albeit temporary, change to the in-court reorganization process for qualifying businesses and individuals whose debt are below the $7.5 million ceiling. For certain small to medium size businesses, a chapter 11 reorganization under the Act may provide the necessary relief from the financial distress inflicted or exacerbated by the COVID-19 crisis.
If you have any questions, please reach out to Alec Ostrow, a partner in the firm’s Bankruptcy and Restructuring Group.
Becker, Glynn, Muffly, Chassin & Hosinski LLP, 2020 All Rights Reserved. This general perspective does not constitute legal advice and is not intended to be relied on for that purpose. You should consult with counsel to determine applicable legal requirements in a specific fact situation.