New Subchapter V draws raves from bankruptcy bar

Quote by: Jim LaMontagne | February 8, 2021

While filings have been slower in Massachusetts than elsewhere in the country, a new streamlined form of Chapter 11 bankruptcy protection for small businesses is getting positive reviews from members of the bankruptcy bar and others as the process reaches its first anniversary.

The Small Business Reorganization Act of 2019 took effect on Feb. 22, 2020. Less than a month later, small businesses began to feel the effects of the COVID-19 pandemic, and what is now Subchapter V of Chapter 11 stands to be an increasingly important tool as small business owners plan for brighter days on the other side of the pandemic.

Initially, only businesses with not more than $2.7 million in debt could file under Subchapter V. But once the pandemic struck, Congress raised the limit to $7.5 million as part of the Coronavirus Aid, Relief, and Economic Security Act. That meant, as of March 27, 2020, a far larger swath of small business debtors could begin taking advantage of Subchapter V, at least for a year. 

In the Massachusetts Bankruptcy Court, 14 Subchapter V cases were opened in 2020, one of which was dismissed. 

By contrast, there have been over 200 Subchapter V cases filed in each of Texas, California and Florida, and 85 in New York.

Bankruptcy attorneys and others with expertise in the area could only hazard guesses as to why the pace of filings in Massachusetts has been slower.

But most agreed that the rate might well pick up once bankruptcy attorneys gain familiarity with the new code provision, and small businesses’ other lifelines, such as Paycheck Protection Program loans and moratoriums on evictions and foreclosures, expire.

Such a trend seems to have already begun nationally, according to Boston turnaround specialist Stephen S. Gray, who cites statistics indicating that small business cases are up 30 percent year over year. Through October, three out of four small business cases and one in five of all Chapter 11 cases had been designated as Subchapter V cases, he noted.

Largely due to Subchapter V’s influence, there has been a 20-percent increase in plans being confirmed within 120 days, Gray said, and 60 percent of those plans have been consensual.

How is Subchapter V different?

One of the primary advantages to a small business of reorganizing under Subchapter V is that certain administrative expenses that the business would incur in a Chapter 11 case have been eliminated. 

Chief among them is the quarterly fee due to the U.S. trustee. That form of relief should not be underestimated, given that two years ago there had been a sharp increase in those fees in larger Chapter 11 cases — up to a maximum of $250,000 per quarter — which has spawned a lot of litigation, according to Boston bankruptcy attorney Adam J. Ruttenberg.

For small businesses, Chapter 11 has long been seen as “way too expensive, too time consuming, too uncertain,” said CPA Stephen B. Darr, senior managing director of Huron Consulting Group and a Region 1 Subchapter V trustee.

Part of the estate’s expenses in big Chapter 11 cases are hefty fees from consultants and other experts, he said.

“And professional fees tend to expand to fill whatever time is available,” Darr said.

With Subchapter V, the process is not only shorter from start to finish — a plan must be filed within 90 days — but such outside experts have less of a role.

Also, under Subchapter V, only the debtor — not creditors or other interested parties — is allowed to submit a reorganization plan. 

Subchapter V also eliminates what is known as the “absolute priority rule,” which previously posed to small business owners a severe risk of losing the equity they held in their businesses by entering Chapter 11, explained Framingham bankruptcy attorney David A. Mawhinney, who is also on the Region 1 panel of Subchapter V trustees.

The absolute priority rule says owners of businesses do not retain their stake unless their creditors above them in capital structure are paid in full.

“That doesn’t ever happen in Chapter 11,” Mawhinney said. “Very rarely are creditors paid in full.” 

However, under Subchapter V, a court may confirm a plan over the objection of unsecured creditors, as long as a debtor pledges to apply to the plan all projected disposable income — a term defined in the Bankruptcy Code — that it receives over a three- to five-year period.

Combined, those two tools give a company a lot of leverage to get a plan confirmed, Mawhinney said.

“They let a mom-and-pop business know that, if they go into Chapter 11, they are not at risk of losing business to creditors,” he said.

What the future holds for businesses

Late last year, Congress passed the second round of COVID-related relief, technically called the Consolidated Appropriations Act, 2021, but did not extend the increase to $7.5 million of the debt limit under Subchapter V. If Congress does not act before March 27, the provision will sunset, and the limit will revert to $2.7 million.

Attorneys uniformly said they hope to see the higher debt limit extended.

While Subchapter V may have temporarily fallen off the radar, Congress clearly understands that the bankruptcy process is going to be an important part of how small businesses gear up for their post-pandemic futures, bankruptcy attorney David A. Mawhinney said.

Specifically, the Consolidated Appropriations Act made small businesses eligible for rent abatement, which should provide some “breathing room,” if the businesses’ landlords are uncooperative with their efforts to reorganize.

The Bankruptcy Code does not allow tenants to rewrite leases, but this new provision will allow businesses to stretch out payments of past due rent over the life of their plan, instead of requiring the businesses to make their landlords whole at the time of confirmation.

The Consolidated Appropriations Act also amends the Bankruptcy Code to authorize debtors in Subchapter V to obtain loans administered by the Small Business Administration, including PPP loans.

There is a “giant caveat” with that provision, however, Mawhinney noted in a recent blog post. The SBA has yet to sign off on the idea that a business in bankruptcy can take out a PPP loan.

“In other words, while the Bankruptcy Code will allow it, unless the SBA changes its current position on eligibility, PPP loans will remain unavailable to companies in bankruptcy,” he wrote.   

Nonetheless, as small businesses start to figure out how to rise from the ashes post-pandemic, Subchapter V is likely an important arrow in their quiver.

“What I’ve seen so far during COVID-19 is that creditors are more open to letting debtors reorganize and not fight them tooth and nail,” said Boston bankruptcy attorney Macken Toussaint.

If the business has any viability, the creditors will let it reorganize, particularly if continuing the business relationship is in everyone’s best interest.

“The more small business we save, the better,” she said.

New role for trustees

Subchapter V also adds a new player into the Chapter 11 mix. While labeled a “trustee,” the person’s function is far different than in a Chapter 7 case, in which a trustee gathers up the estate’s property, disposes of it, and distributes the proceeds to creditors.

“I’m there to foster a consensual plan, work with the creditors and debtor companies, mediate disputes, and avoid protracted litigation,” Mawhinney said.

Given the power granted to debtors under Subchapter V, Mawhinney said his presence also acts as a “bulwark” against those debtors. While he does not represent individual creditors, he can advocate on behalf of the class.

“My job is to investigate [the company’s] financial situation and review the plan,” Mawhinney said. “I can speak to the court and be heard on the plan.”

Fellow Region 1 Subchapter V trustee James S. LaMontagne, an attorney based in Portsmouth, New Hampshire, said that, for many lawyers who practice in the Chapter 11 arena, dealing with a trustee has taken some getting used to.

“A lot of trustees and the court are still trying to feel their way through understanding what the trustee’s role is,” he said.

When Subchapter V was first passed, Ruttenberg said, some of the bankruptcy bar’s reluctance to embark on the process stemmed from a fear that the trustee would come with costs the struggling small business could ill afford. But that fear has since dissipated. 

“The U.S. trustee has been very clear: It does not want trustees to view these cases as big money,” Ruttenberg said, noting that trustees have been told not to hire their own consultants. 

“Some people have been relieved,” he said. “They have seen they are not going to be gouged by trustees.”

The comfort level with the process should only grow with time, participants said.

One of the only reasons that the restaurant industry, in particular, may have been slow to take advantage of Subchapter V is that owners know they will be living with COVID-19 limitations on their operations for a while longer, Mawhinney said.

“The right time to file is usually when things are turning around or about to turn around,” he said. “A company cannot reorganize if it is not able to generate cash.”

If a bar cannot open right now, it could file Chapter 11 tomorrow, but that would not solve its major problem, Mawhinney added.

“Bankruptcy courts do not print money for companies,” he said. 

Nonetheless, Gray said that the only two Subchapter V cases to which he has been assigned thus far have been Boston bars whose landlords had been unaccommodating over their nonpayment of rent and instead had been looking to evict them.

“The simplest way to stop eviction and most foolproof way is to file bankruptcy,” he said.

In the case that has already been confirmed, the plan provides for all of the creditors to receive 100 cents on the dollar, which rarely happens in restaurant cases, Gray said. The business did have to sell its liquor license, however.

The other, still pending case involves a bar near the TD Garden that had been very successful before the pandemic. Once the Celtics and Bruins are back playing before crowds and concerts and other events resume, the business intends to reopen and make its creditors whole over time.

“In most cases, if a business can pay a reasonable payment on debt over time, a consensual plan should be easy to achieve,” Gray said.

LaMontagne agreed that the process is working. He has been appointed to a total of six cases in New Hampshire and Maine, and plans have been confirmed in three, including one involving a construction company and another involving a florist and greenhouse.

“It is certainly helping small businesses get in and out of Chapter 11 a lot quicker,” he said. 

This article was originally posted by Massachusetts Lawyers Weekly and can be found here.