Most bankers understand the major chapters of the bankruptcy code: Chapter 7 (liquidation) and Chapter 11 (reorganization). But what about the relatively new Subchapter V form of bankruptcy?
Enacted just before the COVID-19 pandemic under the Small Business Reorganization Act (SBRA), it provides qualified small business debtors a less expensive, more streamlined process to reorganize debts. While this benefits an important part of the U.S. economy—small businesses comprise 44% of economic activity, create two-thirds of net new jobs, and contribute to American innovation and competitiveness—it poses challenges for banks. By failing to prepare for a possible influx of Subchapter V filings, lenders could incur larger loan losses, higher servicing costs on bankruptcy loans, and higher reserves on their balance sheets. That would especially be the case in a recession when there are more bankruptcy filings by small businesses and other customers. Because they are less capitalized and more concentrated with respect to revenue streams, geography, and management than larger firms, small businesses can be disproportionately affected by downturns and disruption. We saw this a few years ago with the pandemic and related supply chain problems and labor shortages, and we are seeing it now with inflation.
It is anticipated that these types of filings will become more prevalent than Chapter 11 filings. This article explains how banks can mitigate their potential risks by proactively understanding Subchapter V and creating systems and processes to work through its nuances.
Let’s first discuss who is eligible to file under the SBRA. Originally, any person or entity engaged in commercial or business activities that had aggregate noncontingent liquidated debts, both unsecured and secured, no higher than $2,725,625 could—as long at least half of that debt arose from the debtor’s commercial or business activities. However, Congress, which originally passed the law in 2019, increased the debt ceiling to $7.5 million through the 2020 CARES Act—and has extended the sunsetting of that modified amount once. While not entirely clear at this point, many predict the $7.5 million amount will become permanent law.
Eligibility is quite broad and could cover personal guarantors on commercial loans, as long as their debts originate from business operations. This is important because the SBRA could effectively render an unsecured personal guarantee on a commercial loan relatively worthless. These particular personal guarantors could attempt to modify the treatment of their home loans if they qualify for a Subchapter V.
There are specific exclusions from who or what may qualify as a small-business debtor. Public entities do not qualify, nor do individuals or entities that classify as single-asset real estate (SARE) entities. A SARE debtor generates substantially all gross income from a single property or project. Examples include shopping center operators or companies managing office buildings. Most hotels are not considered SARE entities because they tend to generate additional income from gift shops, valet parking, restaurants, or other ancillary activities. Of course, a determination of this is highly fact-specific. Lenders should consult with an attorney for a thorough analysis of individual situations.
How Subchapter V Is Different
Subchapter V reorganizations are significantly different from typical Chapter 11 bankruptcies. First, only the debtor may file a plan in an SBRA case. The code eliminates a creditor’s ability to file a competing plan. That eliminates a tool that, in a Chapter 11 case, allows a creditor to propose plan treatment that may be more attractive than a debtor’s plan, and to obtain confirmation despite the objection of the debtor.
Second, a debtor under Subchapter V may obtain confirmation of a plan without any consenting creditors, which leaves creditors reliant on the law and the judge to prevent confirmation. Typically, a Chapter 11 debtor needs at least one class of accepting creditors to confirm a plan. In an SBRA case, a debtor can literally confirm a plan despite the objections of every creditor.
As a corollary to this significant difference, the absolute priority rule does not apply in a Subchapter V case. The absolute priority rule protects Chapter 11 creditors by requiring the claims of a dissenting class of creditors to be paid in full before any class of creditors junior to the dissenting class receives any value for its claim. Under the SBRA, this protection does not exist. As a result, the equity owners of a debtor could retain their interest in a debtor company—in other words, their equity retains monetary value—despite the fact that the dissenting unsecured creditors do not get paid one penny.
Instead of having to comply with the absolute priority rule, an SBRA bankruptcy debtor must satisfy a “fair and equitable” test as to unsecured creditors, which the debtor can satisfy in one of two alternative ways. First, it could pay its “disposable income” to the standing trustee over a three-to-five-year period. Notably, the definition of “disposable income” is quite narrow, so creditors could get paid very little on their unsecured claims. Specifically, “disposable income” in this application means income received by the debtor that is not reasonably necessary to (1) maintain and support the debtor or a dependent; (2) satisfy domestic support obligations that become first payable post-petition; or (3) ensure the continuation, preservation, or operation of a business. Because the SBRA is relatively new, there is very little case law that clarifies how courts will determine the amount of “disposable income.” But it is apparent that debtors’ lawyers will have plenty of ground to argue that there is very little “disposable income” in most cases due to the definition under the SBRA.
Alternatively, a debtor could distribute some of its property to satisfy the “fair and equitable” test. The debtor would have to prove the property’s value is higher than the value of the “disposable income” over three to five years. For example, if a debtor owned personal property that was no longer needed to operate the business, such as excess land, obsolete inventory, or idle machinery, it would be possible to turn that property over to the Subchapter V trustee to distribute to unsecured creditors and meet the “fair and equitable” test—allowing the debtor to retain its equity interest.
As noted at the beginning of this article, SBRA actions allow debtors to save significant expenses compared to other types of bankruptcy. These fees and costs can range into hundreds of thousands, and even millions of dollars, depending on the bankruptcy’s complexity. Under Chapter 11, creditor committees are often tasked with investigating and litigating potential claims against secured creditors. Since creditor committees do not exist under Subchapter V, debtors will avoid the occasional substantial costs associated with paying professional and legal fees that creditor committees incur. Subchapter V cases are also less expensive for debtors because they do not have to pay the fees of the U.S. Trustee, the independent attorney commonly tasked with protecting the rights of the unsecured class of creditors. (This class usually consists of creditor claims that are too minor to be litigated in bankruptcy court, such as those related to trade payable suppliers or individual employees.)
In addition, unlike with Chapter 11, a debtor does not have to pay all administrative costs when the plan is confirmed under Subchapter V, and a court-approved disclosure statement is not required. Under Chapter 11, disclosure statements are required to provide adequate information about a debtor’s financial affairs so a creditor can decide whether to accept or reject the proposed plan. In addition to saving costs, forgoing a disclosure statement requirement allows debtors to confirm plans much more quickly than in Chapter 11 cases, where a statement typically must be approved 28 days before any confirmation hearing. This difference greatly expedites the bankruptcy process, so creditors must act quickly when dealing with Subchapter V filings.
Subchapter V means differences in the trustee’s role as well. An SBRA proceeding’s standing trustee is appointed to assist all parties, including the debtor, during the bankruptcy. The standing trustee's duties include:
- Accounting for all the property received by the company
- Examining and rejecting any claims against the company
- Conducting a review of the company’s financial condition and business operations
- Reporting any fraud or misconduct to the bankruptcy court
- Appearing at the status conference and materially significant hearings
- Producing a final report of the case for the bankruptcy court
- Assisting, as necessary, facilitation of a reorganization plan
- Distributing certain company property in accordance with the reorganization plan
- Confirming the company’s adherence to the court-approved reorganization plan during the payment period
How To Approach a Subchapter V Case
While a general primer on the law, such as this article, should help bankers manage the Subchapter V process, creditors should immediately contact a qualified creditors rights lawyer to advise from the onset of a case. They should also immediately prepare and file a proof of claim.
Lenders and their attorneys should discuss if the borrower qualifies for SBRA and discuss the possibility of moving to have the case dismissed if there is evidence that it does not. The creditor’s attorney should swiftly contact the standing trustee to obtain any information that has been received from the borrower. The creditor should immediately review the borrower’s loan application and other financials the bank relies on, and identify any basis to except the bank’s debt from discharge. The bank should also analyze the borrower’s projected cash flow and balance sheet to analyze the potential for discharge of the borrower’s unsecured debt. All this should take place relatively quickly so that the creditor’s attorney can attempt to negotiate favorable terms prior to the 90-day deadline to file a plan under Subchapter V.
Creditors should also determine, with legal counsel, whether to make what is known as a “1111(b) election” under the bankruptcy code. This tool can protect unsecured and undersecured (where the value of the collateral is less than the balance of the loan) creditors in certain situations. While there are many complexities to making this election and attorney involvement is critical in certain situations, we believe 1111(b) elections may become more common in Subchapter V bankruptcies. In making the election, the entire claim becomes a secured claim. Second, the election entitles creditors to retain the liens on their collateral until they are paid in full. Third, it entitles creditors to specific plan treatment: A debtor must include payments to the creditor with a present value equal to the amount of the creditor’s secured claim had it not been for the election. Finally, the plan must propose to pay the entire claim in full, over time. (This article from the American Bar Association details the upsides and downsides of a 1111(b) election.)
To manage the likely increase in Subchapter V bankruptcy filings, banks must be diligent. As is normally the case regarding all bankruptcy risk, obtaining and periodically examining collateral is key because of the significant risk of being paid nominally on unsecured debt. Banks should identify any distressed buyer that may qualify as a small business debtor. When negotiating a workout, they should consider utilizing forbearance agreements to incorporate provisions that require debtors to classify expenses in a way that takes advantage of the definition of “disposable income.” Going forward, banks might also consider revising the underwriting standards for loans and loan modifications to incorporate SBRA risk. Proactive steps would include establishing a calculation of “disposable income” in the loan application or during underwriting, and disclosing that calculation to the borrower for confirmation during the origination process. Establishing this at origination or during annual reviews would help in the event the borrower files under the SBRA and tries to claim a much lower disposable income figure to achieve a larger discharge of debt by the court. The bank’s attorneys would have prior calculations that could force better discovery of the true operating capacity of the debtor at the time of bankruptcy.
It is not our intention to make bankers feel like doomsday is upon us as a result of the SBRA. There are some positive items for banks as well as debtors. The SBRA provides a quicker route to rehabilitation for small businesses burdened by unsecured debt. That allows debtors to emerge from bankruptcy with an increased capacity to pay secured debt. And it reduces legal expenses for the debtor due to the expedited process. The SBRA also provides a mechanism to except certain debt from discharge in cases of corporate debtors that obtained loans using fraudulent application.
However, the pitfalls of Subchapter V do outweigh the benefits for creditors. There is significant risk that they may not have time to properly perfect their claims or object to a plan because of the expedited process. This risk is exacerbated because there is no committee of creditors or requirement for a disclosure statement as in a typical Chapter 11 case. It is also likely that any unsecured deficiency claim will be discharged with no distributions based on “disposable income,” leaving many banks facing increased charge-offs and losses. Similarly, individual guarantees that are otherwise unsecured will have remote value since they can be eliminated in an SBRA proceeding, further impairing loans and eliminating other sources of repayment and collection.
Since there is very little SBRA case law to date, it is impossible to predict the law’s full effect. However, bankers should be aware of the process and potential implications, and leverage the knowledge and expertise of legal counsel to help navigate this unexplored legal area. They should also review their portfolios and exposure for any concentration of bankruptcy risk, and consider ways to proactively work with customers to mitigate risks inherent in the SBRA process—or even liquidate at-risk portfolios today.
As a side note, banks should always consider loan sales as an efficient resolution mechanism to minimize losses today (your first loss is sometimes your best loss). Portfolios that have SBRA characteristics may be considered for sale today, even if they are still performing. There are buyers that would be interested in buying these portfolios, albeit price adjusted for the higher risk factor. (This RMA Journal article provides some tips.) Finally, banks should consider factoring potential SBRA losses into forecasting and risk rating systems to ensure they are appropriately recognizing the loss given default and have appropriate loan loss reserves established on their balance sheets.
Christian P. George is the office managing partner of Akerman LLP's Jacksonville office. Christian has a national practice in representing the rights of creditors in all areas of workouts, litigation, and bankruptcy and has handled numerous SBRA matters for financial institutions. Christian can be reached at 904-598-8619 or firstname.lastname@example.org.
Jason Alpert, CRC, is Senior Vice President at a commercial bank with over 18 years’ experience and is a member of the Editorial Advisory Board of the RMA Journal. The views expressed are the author’s alone and do not necessarily reflect the views of any other entity or organization. He is an adjunct professor at the University of Tampa and is active with several nonprofits. He can be reached at email@example.com.