Small Business Reorganization Act of 2019 “Reorganizes” Ch. 11 Bankruptcy Proceedings in Favor of Debtors
On August 23, 2019, the Small Business Reorganization Act of 2019 (SBRA) was signed into law, creating “Subchapter V” in Chapter 11 of the Bankruptcy Code as part of an effort to streamline the structuring process for small businesses (defined as those whose total noncontingent liquidated secured and unsecured debts do not exceed $2,725,625). The new law will go into effect February 19, 2020.
What does this mean for creditors?
Harder to contest Chapter 11 bankruptcy cases
The SBRA makes it more difficult for creditors to contest small business Chapter 11 cases. It favors small business debtors by eliminating the Absolute Priority Rule (APR), which previously required full payment to unsecured creditors for debtors to retain ownership of assets.
The APR will continue to apply for secured creditors.
While this new law only applies to businesses whose debts are less than $2,725,625, debtor businesses may qualify by paying down debts at negotiated discounts, since contingent and unliquidated debts are not calculated in the total.
Previously, debtors would be unable to retain ownership of their business without paying creditors unless: 1) the class of creditors voted to accept the plan, or 2) the equity holder paid a “new value” to the debtor business in a substantial and essential amount.
Because debtors were not able to pay a large amount upfront in cash, they would often attempt to negotiate to buy back ownership, offering to provide new value in payments over several years. Thanks to the immediacy of the APR, these attempts would mostly be unsuccessful, with the result that over 90% of Chapter 11 cases would transfer to Chapter 7 liquidation proceedings instead.
Without the APR in place, debtors can retain ownership of its assets without paying unsecured creditors in full, which means they are more likely to be successful in reorganizing and creditors are less likely to receive substantial payment.
The silver lining: fewer preference lawsuits
It’s not all bad news for creditors. The SBRA also makes changes to Preference Laws that favor creditors by increasing the threshold and due diligence requirements for preference lawsuits.
Under current law, trustees and debtors in possession can file lawsuits to recover preferential transfers made in the 90 days before the bankruptcy was filed, or one year, for insiders. If the amount was less than $13,650, then they would have to file a lawsuit to recover the transfer in the federal district where the defendant resides, rather than the bankruptcy case district.
Under SBRA, the threshold is raised from $13,650 to $25,000 for non-insider defendants, and the trustee or debtor in possession is required to exercise reasonable due diligence, taking into account “a party’s known or reasonably knowable affirmative defenses.”
Prohibitive costs and logistics generally prevent filing of preference suits outside of the bankruptcy case district, so raising the threshold effectively protects most transfers $25,000 and under from recovery. The new due diligence requirement will also help to reduce the number of preference lawsuits.
Actions creditors can take
In light of the new law, creditors and their attorneys, when settling lawsuits with businesses, should:
- Insist on liens upon assets with equity, including during contract negotiations;
- Insist upon entry of a judgment – or, at the very least, an admission of liability – exceeding $2,725,625 in order to disqualify the business from Subchapter V;
- Obtain admissions of wrongdoing in the settlement agreement, since the same debts that are non-dischargeable under other chapters of the Bankruptcy Code remain so under Subchapter V;
- Lean more towards larger transactions (exceeding $2,725,625) instead of smaller ones;
- Focus on anything that may create a lien or property interest, such as a writ of attachment, lis pendens, or judgment lien, as these will increase the chance of a substantial payment.
In order to find more successful outcomes under the new Subchapter V, creditors should be more selective about extending credit, insist on obtaining liens wherever possible and monitor the assets that secure the liens on a regular basis.
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