Planning Ahead for the Small Business Reorganization Act of 2019

Sep 5, 2019

By Thomas A. Lerner | Related Practice: Financial Services

The Small Business Reorganization Act of 2019 will become effective on February 20, 2020. It amends existing provisions of the Bankruptcy Code to streamline the process for small business reorganizations by creating something of a hybrid between Chapter 11 restructuring and Chapter 13, which is designed to address wage-earner reorganization. The objective appears to be to provide a more meaningful reorganization remedy for small businesses. Absent this amendment, the administrative costs of a Chapter 11 case were so onerous as to make a Chapter 11 case prohibitively expensive for small businesses. Bankruptcy form
A “small business debtor” is one who is engaged in commercial or business activity, but excludes from the definition those whose primary activity is owning or operating real property. The unsecured debt ceiling to qualify as a small business debtor is $2,566,500 (as of 2019), which is subject to annual adjustment for inflation. Debts owed to insiders or affiliates are excluded from this cap.

Practice tip: Odd as it may sound, if your borrower’s financial statements disclose that they are very close to qualifying as a small business debtor, the lender may be better served by relaxing constraints on a credit line, to let the debtor’s unsecured debt rise above the qualifying amount to be a small business debtor. This bears a close analysis as the true value of the collateral held by a creditor will be at issue in determining the extent to which the lender is undersecured. Allowing an imminently insolvent debtor to become further in debt to the lender conflicts with the aphorism that “your first loss is your least loss” and should only be considered in unusual circumstances.

Like in Chapter 13 cases, a Trustee is appointed in a small business case, but the Trustee has limited functions. Like in Chapter 11 cases, the debtor remains in possession. Only the debtor may file a reorganization plan, but that plan must be filed within 90 days unless the court extends that period. Extensions should not come freely—they are to be limited to where “the need for the extension is attributable to circumstances for which the debtor should not justly be held accountable.” This is a tightening up from Chapter 11 practice.

The debtor’s plan will be easier to confirm, and easier to cram down. Unlike a Chapter 11 case, it no longer needs to have at least one impaired creditor class consenting to the plan. Past practice in Chapter 11 cases has been to gerrymander the creditors to have a pool of “convenience class” creditors who are owed small sums and nominally impaired and are deemed to consent. That manipulation of creditor classes will no longer be necessary in small business cases.

Like in a Chapter 13 case, the plan requires the commitment of all of the projected disposable income of the debtor in a 3-5 year period to be committed to the plan. “Disposable income” means the debtor’s income “that is not reasonably necessary to be expended for maintenance and support” of the debtor or debtor’s dependents, or a domestic support obligation or for the continued operation of the business. For creditors, this is where the battle needs to be fought. A debtor typically files schedules that demonstrate that their ordinary expenses exceed their income—which is likely why they are in bankruptcy court to begin with. But if that is the basis for determining the amount of plan payments, then it begs the question of what will be available to pay creditors.

Practice tip: Under this Act, the debtor may modify the rights of a secured creditor whose claim is secured only by a security interest in the debtor’s residence, if that collateral was taken in exchange for financing primarily in connection with the small business (rather than to acquire the real property). Thus, a creditor with a security interest in business assets may want to leave some collateral behind simply to avoid a modification of the creditor’s rights relating to the residential real property.

Bankruptcy filings in Western Washington have plummeted to one-third of the volume that they were in 2010. The most obvious reason for this has been the improvement in the economy. A secondary reason has been the increased use of receiverships, which generally provide greater control over an orderly wind-up of a business with a better return on collateral at a lower administrative cost than a Chapter 11, and closer to fair market value returns than the meat-cleaver approach of a Chapter 7. The Small Business Reorganization Act of 2019 contains debtor-friendly changes to the Bankruptcy Code, in a departure from bankruptcy amendments over the past 25 years. It does invite speculation as to how our divided government reached agreement on these changes, and the driving forces behind them.