COVID-19 Be Dammed, a New Weapon for Owners to Save their Distressed Business

SYNOPSIS: privately owned businesses are struggling. Many are likely to “go under.” But what does it mean to go under? There are legal tools available to help businesses cleanse their balance sheets and start fresh. Chapter 11 is one, but it is often too expensive with an outcome that is too uncertain. Other tools exist but they lack some of the benefits of chapter 11. Enter stage left: Subchapter V of chapter 11- a new tool (new as in it didn’t exist until February), which (like all the other tools) are available even if your business received PPP or other federal funds relate to COVID-19 relief.

If your business is at death’s door or otherwise struggling, because of COVID-19 or any other reason, you must be trying to turn things around and/or how to walk away.

Operational Issues

There are operational fixes you may be able to make. A brick and mortar retailer can go online, and a restaurant can move to a takeout-only model, as examples. Moves like these, however, do not address balance sheet problems.

Balance Sheet Issues

Examples of balance sheet problems:

• A lease for a physical space that is way too big (e.g. a takeout-only restaurant doesn’t need a dining room; a retailer that goes all online needs a backroom or warehouse, but not a store and certainly not any space in a retail area where there is foot traffic).
• A line of credit and/or a term loan that the business was able to service before the downturn but which it doesn’t come close to servicing now.
• Accounts payable that the business likewise has no chance of being able to pay in full given current circumstances. 

Hold or Fold?

What do you do? If you don’t have personal guarantees then maybe you can walk away and avoid any personal liability, but even then you may be walking away from a business that could survive if you use the right legal tools to deal with the balance sheet problems.

Chapter 11

Chapter 11 bankruptcy is a term many business owners have heard but which few really understand. The reality for many businesses is that it does not work all that well anymore. Why? Simply put, a traditional chapter 11 case can be too costly, too time-consuming, and can be difficult to successfully complete.

Alternatives to Chapter 11 Bankruptcy

The result: a lot of failed chapter 11 cases, more businesses liquidating in chapter 7, and the rise of the use of Chapter 11 alternatives, such as receiverships, assignments for the benefit of creditors (ABCs) and Article 9 sales.  

A New Tool for Struggling Business Owners- Subchapter V

Enter stage left: subchapter V of Chapter 11, which was enacted in 2019 as part of the Small Business Reorganization Act of 2019, but which only went into effect on February 19th, just in time for the economic meltdown that came on the heels of COVID-19.

Subchapter V of chapter 11 was designed to deliver the benefits of traditional chapter 11 at a fraction of the cost and without some of the onerous confirmation requirements that so often stand in the way of reorganization.

All About Bob

Here’s a story about Bob. Read it and ask yourself if Bob reminds you of you. If he does, then subchapter V may be exactly the medicine you need. Keep in mind, though, subchapter V may be the right tool regardless of who owns your company (i.e. whether it is owned by an individual, a family, private equity fund (subject to certain affiliate debt aggregation rules), etc.).

Bob and his wife started BobCo, Inc. five years ago. BobCo is in the business of making and selling widgets. Due to a combination of factors, BobCo is suffering financially. BobCo is highly leveraged, as its bank debt is too much to service given the economic realities facing the widget industry today. Rent is too high. A liquidation of BobCo’s assets wouldn’t pay the bank off in full, let alone BobCo’s other creditors, which it’s fallen behind in paying. Additionally:

1.    Bob and his wife are the sole shareholders of BobCo.

2.    BobCo owes the Bank approximately $1.2 million. The Bank has a security interest in all of BobCo’s assets.

3.    BobCo is in covenant default on its loan from Bank and has very little cash with which to make the next payment.

 4.    Several of its trade vendors have stopped doing business with BobCo and have filed lawsuits to collect on the unpaid amounts. Bob expects other vendors will sue BobCo soon and continuing to operate will become increasingly difficult.

5.    BobCo leases a warehouse for its widget operations. BobCo is late on rent.

The first question that needs answering is whether BobCo qualifies for subchapter V.

Can BobCo File Under Subchapter V?

BobCo qualifies to take advantage of Subchapter V because (a) its aggregate debts are less than $7,500,000 (the limit is actually higher, as the cap doesn’t consider contingent or unliquidated debt); and (b) at least 50 percent of its debts arose from commercial or business activities. If Bob has personally guaranteed some of the debt he may also want to (and be able to) file a personal Subchapter V chapter 11.

Once BobCo files Chapter 11, it becomes a debtor-in-possession (“DIP”), just like in a traditional chapter 11 case. This means, among other things, that unlike in chapter 7. Bob will not have to give up control to a trustee when the bankruptcy is filed. Bob will, however, have certain duties to comply with.   

One of these duties is to work with a Subchapter V trustee, appointed by the United States Trustee (UST). The role of a Subchapter V trustee may be generally described as a combination of a “financial guru” and a “mediator” – she exists to supervise and monitor the chapter 11 case and help facilitate a plan of reorganization.

Benefits of Subchapter V as Compared to “Regular” chapter 11

Summary

The creation of the Subchapter V trustee appears, so far, to be a good thing (recall, Subchapter V has only been in use since February) because experience to-date suggests that such trustees view their role as collaborative with the debtor (as opposed to adversarial, as is the case with chapter 7 trustees and “regular” chapter 11 trustees). There are other significant advantages to a Subchapter V chapter 11 as compared to a traditional chapter 11. These include:

• An official committee of unsecured creditors will not normally be appointed.
• There are no quarterly fees that must be paid to the UST
• There will generally be no requirement to file a disclosure statement before filing a chapter 11 plan
• Only the debtor (in this case, BobCo) can file a chapter 11 plan
• It is much easier to confirm a plan (and confirmation of a plan is the hallmark of a successful chapter 11 reorganization. 

To be clear, I am neither suggesting that subchapter V is a panacea nor that it is the path a company should go down if that company is eligible to do so. Traditional chapter 11 could still be the better path, as could one or more of the non-chapter 11 alternatives. This stuff is not cookiecutter and you need to hire a smart and experienced restructuring attorney to help you through the decision making. And, while slightly off-topic, time is not on your side. The sooner you do this the more options you will have. The single most common mistake I see companies make is waiting too long to seek help.

Moving on, let’s look at the key advantages of a subchapter V bankruptcy over a traditional one, from BobCo’s perspective.

No Creditors’ Committee & No UST Quarterly Fees

Subchapter V eliminates the automatic appointment of an official committee of unsecured creditors unless a court orders otherwise for cause. While committees are important parties in interest in Chapter 11 bankruptcies, the cost of hiring counsel to represent the committee and actively participate in Chapter 11 is costly and onerous on small business debtors.

Also absent in a Subchapter V case is the UST quarterly fee. There simply is none.

No Disclosure Statement

BobCo is not required to file a disclosure statement unless the court orders otherwise for cause. If the court does so order, the existing disclosure statement requirements for small business cases in Bankruptcy Code §1125(f) will apply to BobCo.

BobCo’s Plan of Reorganization

Unlike traditional chapter 11 cases, in which parties other than the debtor are allowed to file a chapter 11 plan, Subchapter V is reserved for the debtor – only the debtor can file a plan. And while the debtor must file a plan within 90 days of the bankruptcy filing unless the court extends the deadline for doing so, there is no hard deadline by which the debtor must get its plan confirmed. 

Subchapter V also does away with the requirement that the plan contain “adequate information.

The most groundbreaking changes Subchapter V made are those that govern what it takes to confirm a chapter 11 plan. Confirmation under traditional chapter 11 is far more onerous as compared to under Subchapter V.

Bankruptcy Code §1191(b) revises the cramdown rules to allow cramdown confirmation even if all impaired classes do not accept the plan. And, if a plan is confirmed under the cramdown provisions of §1191(b), it allows administrative expenses to be paid over a period of time through the plan, rather than having to be paid in full on the effective date. The cramdown requirements for treatment of secured claims under §1129(b)(2)(A) will, however, still apply. Further, under Subchapter V, Bob and his wife can retain their equity in BobCo even if non-accepting creditors are not paid in full, so long as the plan does not discriminate unfairly, and is fair and equitable with respect to each class of claims or interests. This is, perhaps, the biggest gamechanger of Subchapter V as compared to a traditional chapter 11, in which a debtor must comply with the “absolute priority rule,” which in turn requires any equity holder seeking to reorganize under Chapter 11 to contribute to the plan to maintain their equity interest.

Conclusion

Chapter 11 exists, in large measure, to give a company a fresh start; a way to fail, pay what it can, based on the value of its assets, and move onto becoming a productive employer, taxpayer, and wealth creator for its owner. Over the years since it became law in 1978, partly due to prior amendments, it became much more difficult for smaller companies to use it in the way it was intended. Subchapter V is a good thing and it will allow many more companies to use chapter 11 in the way it was originally intended. That said, there are several other options that a skilled corporate restructuring attorney should always help you consider before helping you decide which one is best for your circumstances.

P.S. If you want to learn more about how to use the legal system to clean up your balance sheet, be sure to check out Opportunity Amidst Distress. It will consist of three back-to-back one-hour webinars on June 23rd (every registrant will also get unlimited on-demand access). I’m one of the faculty but you won’t have to watch just me because there are more than a dozen other faculty members. It is being co-produced by a number of leading industry organizations, including Association of Insolvency & Restructuring Advisors (AIRA); Financial Executives International- Long Island Chapter (FEI-LI); Financial Executives International- New York City Chapter (FEI-NYC); Midwest Business Brokers and Intermediaries (MBBI); New York Institute of Credit (NYIC); Private Directors Association (PDA); Turnaround Management Association- New York City Chapter (TMA_NYC); and Turnaround Management Association- New Jersey Chapter (TMA-NJ).