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The Impact of the CARES Act on Small Business Reorganizations

April 06, 2020

Small businesses have traditionally had difficulties reorganizing under Chapter 11 of the Bankruptcy Code. The legal fees necessary to prepare a plan and disclosure statement and navigate the confirmation process were often prohibitively expensive. Further, the reporting requirements and United States Trustee fees mandated by Chapter 11 added significant expenses to the already struggling debtor’s cash flow.

The Passage of SBRA. Congress made certain changes to the Bankruptcy Code in 1994 in an effort to make it easier for small business debtors to survive the reporting requirements of Chapter 11 and confirm a plan of reorganization, but these changes were generally viewed by bankruptcy practitioners as confusing and of questionable value. In 2019 Congress passed the Small Business Reorganization Act of 2019 (SBRA) in an effort to codify a comprehensive “Chapter 11, Subchapter V” (Sub V) that will control how small businesses reorganize going forward. In order to participate in the Sub V process, the debtor originally had to have less than $2,725,625.00 in total secured and unsecured debt. This dictated that Sub V debtors would, almost by definition, be mom and pop small businesses, many of whom would have SBA loans as the principal debt.

Raising the SBRA Debt Limit. As we have seen, the American economy has come to a jolting halt in the last two weeks. It is clear that major industries such as retail, airlines, hospitality and automotive are going to suffer massive disruptions in income. This is going to set off an enormous ripple effect throughout the rest of the economy, likely driving large numbers of businesses to file for bankruptcy relief. In order to anticipate this demand, and deal with these cases effectively, the Coronavirus Aid, Relief and Economic Security Act of 2020 (CARES) has raised the debt limit for SBRA cases to $7,500,000.00. This will apply to all cases filed between March 27, 2020 and March 27, 2021. After that time, the debt limit will presumably revert to $2,725,625.00.

Impact of the New Debt Limit. With the debt limit increased to $7,500,000.00, a new class of creditors is going to attempt to take advantage of the Sub V provisions. These debtors could represent larger companies, specifically including light manufacturing companies, service providers, construction and grading companies and companies that own multiple hotels or restaurants.

Traditionally creditors, particularly secured creditors, had significant leverage with regard to these types of debtors. Secured lenders could force the debtor to:

  1. Submit a detailed disclosure statement;
  2. Strictly comply with provisions regarding the contents of a Chapter 11 plan of reorganization;
  3. Propose a plan that repaid all of the debtor’s creditors in full, over a reasonable amount of time (the Absolute Priority Rule); and
  4. Obtain a confirming vote from at least one class of impaired creditors (which the secured creditor would often try and control by voting its unsecured claim against confirmation of the debtor’s plan).

Under CARES, larger companies can take advantage of the expedited Sub V plan process, where there are i) limited reporting requirements, ii) a simplified form disclosure statement, iii) probably a form plan of reorganization in the future as the Act unfolds, iv) requirements that the debtor only need devote its reasonable post-petition disposable income to payment of its creditors under the plan, v) a provision that only the debtor can file or propose a plan; and, perhaps most importantly, vi) no voting among classes of creditors for confirmation of the plan. A Sub V debtor must propose its plan within ninety (90) days from the Petition Date, but the confirmed plan can pay out from three (3) years to five (5) years.

SBRA does not relieve debtors from

  1. having to adequately protect a secured creditor for any diminution in the value of the secured lender’s collateral;
  2. accounting for a secured creditor’s cash collateral, and taking steps to ensure that the debtor is only using cash collateral for appropriate, approved purposes in accordance with a cash collateral order;
  3. repaying secured creditors the current fair market value of their collateral over a period of time that would trade in the market for non-distressed loans, at a market interest rate; and
  4. demonstrating that the debtor’s income and expenses are such that it is actually feasible to consummate and perform under its proposed plan of reorganization.

While secured creditors in Sub V cases have retained many of the traditional levers that they had under a typical Chapter 11 plan, after the expansion of the debt limits provided by CARES, secured creditors and their counsel are going to have to be prepared to rapidly assess and take action to deal with an onslaught of larger cases that are going to move very quickly through the Sub V process.