As the ongoing COVID-19 pandemic creates upheaval in the lives of individuals and business, attention has been focused largely on the Coronavirus Aid, Relief and Economic Stimulus Act (CARES Act) and its refunding and enlargement. However, even before most businesses rushed to banks, flooding the Small Business Administration with Paycheck Protection and Emergency Disaster Relief loan applications, Congress passed the Small Business Reorganization Act of 2019 (SBRA) with little fanfare. The SBRA amended the existing Chapter 11 Bankruptcy Code to include a new Subchapter 5, which is geared to small businesses.
Background and Eligibility:
Although the SBRA seems tailor-made for the current economic climate, House Republicans actually introduced the bill in June 2019. The bill was largely a response to small businesses owners’ growing concerns about the massive costs and complexities of a traditional Chapter 11 Bankruptcy. The law went into effect on February 19, 2020. At inception, to qualify for Subchapter 5, a business’s debts had to fall below the $2,725,625.00 threshold. However, the CARES Act temporarily increased the maximum debt threshold to $7,500,000 for cases filed on or before March 27, 2021. Importantly, both debt caps exclude debts owed to insiders and affiliates.
No Creditors’ Committee – In the past, a business was forced to undertake the long and complicated process of a traditional Chapter 11 reorganization if they desired to continue operations post-bankruptcy. The most daunting part of the reorganization process is usually the submission and approval of the actual reorganization plan. Specifically, the debtor is often in a seemingly endless battle with creditors, who are organized in a Creditors’ Committee, to approve the plan. The approval process alone can take several months to a year, with any secured creditor or major unsecured creditor having the power to veto the reorganization plan. In contrast, Subchapter 5 eliminates the Creditors’ Committee. Instead, the Bankruptcy Court appoints a Trustee to oversee the process of reviewing the debtor’s financial schedules and proposed reorganization plan. Further, a Subchapter 5 attempts to expedite and simplify the reorganization plan process by requiring the debtor to submit a reorganization plan within 90 days of the bankruptcy petition and by eliminating the requirement that the debtor submit a separate financial disclosure statement in support of the plan.
No Strict Priority Rules – In a traditional Chapter 11 Bankruptcy, the Court recognizes and strictly adheres to priority rules, meaning certain debts have preferential treatment over other debts. For example, administrative costs and attorney fees typically have priority over secured debts and secured debts typically have priority over unsecured debts. After the bankruptcy estate satisfies all costs and claims from the highest priority creditor class, the bankruptcy estate satisfies all costs and claims from the next highest class. This process repeats until the bankruptcy estate does not enough funds to fully satisfy all costs and claims within a given creditor class. At that point, the bankruptcy estate distributes its remaining funds on a pro-rata basis to all creditors within this creditor class. Due to the complex and prolonged nature of a standard Chapter 11 reorganization, administration costs, such as attorney’s fees, substantially reduce the bankruptcy estate and, therefore, significantly diminishing the funds paid to creditors. Conversely, in a Subchapter 5, although the Court continues to test for reasonableness and the Trustee continues to make sure the estate considers creditors’ interests, the debtor has much more discretion about the estate’s distributions . By giving debtors more discretion, through the SBRA, it is expected that reorganization plan confirmations will be significantly accelerated.
While it is too early to evaluate the true impact of this new bankruptcy option, given the increased likelihood of a sustained economic downturn from the novel COVID-19 pandemic, it is extremely likely many businesses will seek relief by filing bankruptcy and many small businesses will attempt to utilize Subchapter 5 enumerated through the SBRA. Without strict priority tiers in the Subchapter 5, smaller unsecured creditors will likely increase recoveries in reorganization plans, though a significant portion of the increased recoveries will be at the expense of secured creditors and major unsecured creditors. However, a portion of the increased recoveries will come from a decrease in administrative costs. Assuming the SBRA can deliver on its promise of a faster and cheaper bankruptcy option, Subchapter 5is likely to become the preferred form of reorganization for eligible debtors.
What Can Creditors Do?
First and foremost, it is more important now than ever to practice due diligence when extending credit to new and existing customers. Even with longstanding business relationships, simply pulling an updated business credit report or receiving credit alerts will help a credit manager identify those customers whose credit terms must be revised to more accurately reflect current risk and those customers that no longer qualify for credit. If a transaction ultimately goes awry, securing a new or an updated credit application, preferably with a well-qualified personal guarantee, can be the difference between a successful recovery or losing thousands of dollars of product or capital.
Second, every credit manager should have an updated, uniform policy for recovering delinquent accounts. In current market conditions, the financial health of businesses and consumers can greatly vary day by day. As such, any payment delays, even a few days, should cause credit managers to take immediate notice. While a customer may have the best intentions and ultimately pay, it is important to initiate communication as soon as possible and make persistent and professional request for payment.
Lastly, especially in the current climate, a credit department can easily become overwhelmed with the task of chasing an ever-growing number of delinquent accounts. As in the past, when it becomes clear a customer intends to remain delinquent, the matter should be forwarded to a third-party collection partner as soon as possible. Timely transfer of delinquent accounts can both increase recovery and create more time for credit departments to focus on new customers and existing, productive accounts.