Will the SBRA Save Your Business, or Ruin It?

April 13, 2019

? David Duperrault [email protected]

The Small Business Reorganization Act (SBRA) (H.R.3311; S.1091) radically changed the law governing small business bankruptcies. Effective on February 19, 2020, the SBRA made it much easier, faster and cheaper for a small business to reorganize under Chapter 11. Perhaps most appealing to small business owners is that they can now retain ownership of the business even if creditors are forced to take deep discounts on their claims. 

The economic devastation caused by the COVID-19 pandemic has pushed many small businesses into insolvency. For them and their owners, the SBRA is a lifeline. The business can reorganize and continue to operate, and the owners can keep their stake even if creditors receive less than they would in a liquidation.

But this is a double-edged sword. Every company that reorganizes under the SBRA has creditors—landlords, lenders, suppliers and other vendors—who will suffer when their accounts receivable are fully or partially extinguished.  For many of these enterprises, whose revenues already have fallen precipitously, further losses caused by bankrupt customers could threaten their survival.

The SBRA escalates the risks for those who extend credit by making bankruptcy more appealing and less painful for small businesses and their proprietors.  Creditors face the prospect of more cases being filed under Chapter 11—cases in which they will have fare less leverage. As discussed in greater detail below, credit managers should consider curtailing credit limits, scrutinizing credit reports and financial statements, requiring security, and even demanding letters of credit or personal guaranties. 

Eligibility

Although the SBRA was signed into law in 2019, before the novel coronavirus struck, it has been amended by the Coronavirus Aid, Relief and Economic Security Act (CARES Act) of 2020 (S.3548) so that many more small firms are eligible to reorganize. Now a business with up to $7,500,000 in debts qualifies, although after March 27, 2021, the debt limit will revert to $2,725,625. Secured and unsecured debts are included, debts to insiders and affiliates are excluded, and at least 50% of the debt must have arisen from commercial or business activities. Individuals, corporations, LLCs and other entities qualify. The SBRA adds the requirement that not less than 50% of that debt has arisen from commercial or business activities. Debtors whose primary activity is to own or operate more than one parcel of real property are eligible.

Speedier, Simpler, Cheaper

The SBRA removed or lowered many of the barriers that formerly discouraged small businesses from reorganizing under Chapter 11.

·      Only the debtor may file a plan. The small business debtor has the exclusive right to file a plan of reorganization. This precludes the delays and expensive litigation that results when creditors seek to file a competing plan. 

·      90-day deadline. The debtor must propose a plan within 90 days after filing the petition that commences the SBRA case. 

·      Streamlined confirmation process. Protracted fights over the sufficiency of a disclosure statement are avoided because the small business debtor need not even file one unless the court orders otherwise. Instead, the plan itself must include (i) a brief history of the debtor’s business operations; (ii) a liquidation analysis; and (iii) projections of the debtor’s ability to make payments under the proposed plan. Even if the court requires a disclosure statement, expedited procedures for approval and confirmation of the plan apply.

·      No creditor committees. Except in unusual circumstances, where the court orders otherwise for cause, an official committee of creditors will not be appointed in a small business case. This can reduce costs significantly because ordinarily the debtor must pay the committee’s expenses including the fees of its lawyers, accountants and financial advisors.

·      Plan approval by creditors is not required. In other chapter 11 cases a plan may be confirmed only if it has been accepted by at least one class of impaired creditors. That requirement has been eliminated in small business cases provided the plan does not discriminate unfairly and is “fair and equitable.” 

·      New definition of “fair and equitable”. Under the SBRA a plan is fair and equitable if (i) all of the debtor’s projected disposable income over the next 3 to 5 years will be applied to make payments under the plan; or (ii) the value of property to be distributed under the plan is not less than the debtor’s projected disposable income. This change should make it far easier for many debtors to confirm a plan, and to successfully complete it. 

·      Protections for creditors. Creditors can take some comfort from the SBRA requirements that in order to confirm a plan the court must find that (x) the debtor will be able to make all payments under the plan; or (y) there is a reasonable likelihood that the debtor will be able to make all payments under the plan, and the plan provides appropriate remedies, which may include the liquidation of non-exempts assets, to protect the holders of claims or interests in the event that the payments are not made. 

·      Modification of some residential mortgages permitted. Under the SBRA the debtor may modify the rights of the holder of a claim secured only by a lien on the principal residence of the debtor if the secured debt was (a) not used primarily to acquire the real property; and (b) used primarily in connection with the small business of the debtor. This gives the small business debtor greater flexibility than is offered by Chapter 13 or the standard Chapter 11 regime. 

·      Some priority claims may be paid through plan. In other Chapter 11 cases, unless all impaired classes consent, administrative expenses must be fully paid in cash upon confirmation of the plan. These expenses include the debtor’s operating expenses during the Chapter 11 case (rent, payroll, taxes, etc.) and professional fees. For cash-starved debtors this is a barrier to confirmation. Under the SBRA payment of these expenses may be stretched out over the life of the plan.

Retention of Ownership of Small Business Debtor

The “absolute priority rule” applicable in most bankruptcy cases generally requires that, in order for a business owner to retain her stake in the business, creditors must either be paid in full or agree to their treatment under the plan. The only exception is for owners who contribute significant new value, which usually means new capital. This rule is relaxed under the SBRA. The plan will be confirmed as long as it is “fair and equitable,” meaning that (i) all of the debtor’s projected disposable income over the term of the plan will be applied to make payments under the plan, or (ii) the value of property to be distributed under the plan is not less than such projected disposable income. This will make Chapter 11 far more attractive to many small business owners.

Who’s in Control? The small business debtor is a “debtor in possession” (DIP) with many of the same powers and duties as other Chapter 11 debtors in possession. The DIP continues to operate the business, hires its own professionals, and formulates the plan or reorganization. However, a trustee is also appointed automatically to exercise many of the powers given to trustees under Chapters 12 and 13. For example, the trustee is to ensure that the debtor commences making timely payments required by a confirmed plan. If a plan is confirmed under without the consent of all impaired classes, the trustee makes all payments under the plan. The trustee examines proofs of claim and object to improper filings; opposes the debtor’s discharge, if advisable; and investigates the conduct, assets, liabilities, and financial condition of the debtor, the operation of the debtor’s business and the desirability of the continuance of such business, and any other matter relevant to the case or to the formulation of a plan.

What’s a Creditor to Do?

Under the SBRA, creditors have far less leverage. That means they need to take steps to minimize their risk of loss before a small business customer files for reorganization. Before extending credit they should consider (i) evaluating a customer’s creditworthiness more thoroughly, with credit applications, financial statements, credit ratings and references; (ii) limiting their exposure by reducing credit limits and shortening terms; (iii) demanding COD or payment in advance from some customers; (iv) monitoring their accounts receivable carefully and strictly enforcing the terms of payment; (v) taking and perfecting a security interest in the products they sell or other collateral to secure payment; and (vi) insisting on a letter of credit or personal guaranty to support larger obligations.

? David Duperrault [email protected]

LAWYER ADVERTISING MATERIAL. The purpose of this article is to bring attention to developments in the law. It is not intended as legal advice for any particular client or any specific situation. Readers should consult with counsel of their choice regarding their own needs and circumstances and any questions they may have.

References:

Analysis of the Small Business Reorganization Act (SBRA), Robert G. Harris, California Lawyers Association, Business Law Section, Insolvency Law Committee. https://calawyers.org/business-law/analysis-of-the-small-business-reorganization-act-sbra/

The Small Business Reorganization Act: Big Changes for Small Businesses, Lei Lei Wang Ekvall and Timothy Evanston, American Bar Association, 2-14-20. https://www.americanbar.org/groups/business_law/publications/blt/2020/02/small-business-reorg/