The Benefits of Subchapter V — But Are You Guaranteed To Stay?

Benefits of Subchapter V

On August 23, 2019, Congress enacted the Small Business Reorganization Act of 2019 (“SBRA”), which became effective on February 19, 2020, creating Subchapter V of Chapter 11 of the Bankruptcy Code (11 U.S.C. §§ 1181-1195 “Subchapter V”). Subchapter V made several substantive and procedural changes to the Code, which were intended to streamline the Chapter 11 process for small business debtors by eliminating certain requirements that made it more difficult and expensive for small businesses to reorganize. For those who qualify, Subchapter V is now an advantageous way to reorganize a business.

The key modifications to Chapter 11 and characteristics of Subchapter V include:

• Requirement to file a plan quickly. As part of the give-and-take of Subchapter V, debtors generally are required to file a plan within 90 days after entering bankruptcy, absent a showing of circumstances “for which the debtor should not justly be held accountable.” This expedited plan timeline may not be ideal for some debtors, but for many debtors it functions as a minor inconvenience given the more relaxed economic standards and factors discussed below. The circumstances for which the 90-day period may be extended also can be somewhat flexible.
• Modification of the absolute priority rule. The “absolute priority rule” provides that existing owners of a debtor may not retain their equity interest in the debtor over the objection of a class of unsecured creditors, unless the unsecured class is paid in full or the owners contribute material new value into the debtor. In what is perhaps the single most important modification of the traditional Chapter 11 requirements to a non-publicly held company, that rule simply does not apply in a Subchapter V case — as long the plan provides that unsecured creditors will be paid the debtor’s “disposable income” for a period of three years (or up to five years if extended by the bankruptcy court). In that event, equity holders of a Subchapter V debtor may continue to own and manage their business, even when unsecured creditors are paid a de minimis sum and vote against the plan or object to confirmation.
• No requirement to file a disclosure statement. A Subchapter V debtor is not required to file an accompanying Chapter 11 disclosure statement, unless ordered by the bankruptcy court for cause. The elimination of the disclosure statement requirement significantly reduces cost of preparing a plan and expedites the confirmation process.
• No competing plans. Only a debtor may file a Chapter 11 plan in a Subchapter V case. This limitation allows Subchapter V debtors to focus on their plan without having to worry about exclusivity or the distraction posed by a competing plan proposed by creditors.
• Modification of plan payments for administrative expense claims. A Subchapter V debtor may pay administrative expense claims over the term of the plan. In contrast, in traditional Chapter 11 cases, the debtor must pay administrative expense claims on the effective date of the plan or in the ordinary course of business. This allows a Subchapter V debtor to amortize some of the costs of filing bankruptcy.
• Reduced administrative expenses and creditor interference. Subchapter V provides that an official committee of unsecured creditors will not be appointed unless ordered by the bankruptcy court for cause. The elimination of a creditors’ committee significantly reduces administrative expenses and overbearing oversight that may sometimes scuttle traditional Chapter 11 cases. Relatedly, Subchapter V debtors are also excused from paying United States Trustee quarterly fees.
• The concept of the debtor in possession survives with some oversight. A Subchapter V debtor’s management team may continue to manage the debtor’s affairs as debtor in possession. However, a Subchapter V trustee is appointed to monitor the debtor’s affairs, evaluate the debtor’s assets, assess the debtor’s prospects for success, and make recommendations regarding confirmation of the debtor’s plan. In practice, a Subchapter V trustee generally is more helpful to the debtor than not, especially when dealing with creditors who may be adverse to the debtor.

Eligibility for Subchapter V: Debt Amount and Recent Adjustments

To be eligible for Subchapter V, a debtor must (1) meet the definition of a “small business debtor”; and (2) elect to be treated as a debtor under Subchapter V. Prior to the COVID-19 pandemic, the Bankruptcy Code defined a small business debtor as a business “engaged in commercial or business activities . . . that has aggregate noncontingent liquidated secured and unsecured debts . . . in an amount not more than $2,725,625 (excluding debts owed to 1 or more affiliates or insiders) not less than 50 percent of which arose from the commercial or business activities of the debtor.”

As part of the Coronavirus Aid, Relief, and Economic Security Act of 2020, Congress temporarily increased the debt limit under this Bankruptcy Code section from $2,725,625 to $7.5 million until March 27, 2021. This increase made it possible for more substantial companies, with significant contingent and unliquidated debts that might otherwise be compelled to reorganize under the traditional Chapter 11 provisions, to qualify for Subchapter V’s more relaxed standards. On March 27, 2021, Congress passed the COVID-19 Bankruptcy Relief Extension Act, which extended the increased debt cap provision through March 27, 2022. Although Congress did not act immediately, on June 7, 2022, Congress subsequently passed the Bankruptcy Threshold Adjustment and Technical Corrections Act, which retroactively reinstated the $7.5 million debt threshold for an additional two years. Accordingly, until at least June 2024, Subchapter V will remain a viable option for a much larger pool of small and mid-sized businesses to reorganize.

In re National Small Business Alliance, Inc.

While bankruptcy courts have held that a debtor’s Subchapter V election may be revoked in situations where the debtor is ineligible for Subchapter V, see In re Serendipity Labs, Inc., 620 B.R. 679 (Bankr. N.D. Ga. 2020) (ordering the Subchapter V election revoked where debtor was ineligible for Subchapter V), until recently no bankruptcy court had considered whether a bankruptcy court has the authority to revoke an eligible debtor’s Subchapter V designation. In what the bankruptcy court described as an issue of first impression, U.S. Bankruptcy Judge for the District of Columbia Elizabeth L. Gunn considered whether, instead of dismissing a debtor’s bankruptcy case for failure to comply with the Subchapter V requirements, the bankruptcy court had the authority simply to revoke an otherwise eligible Chapter 11 debtor’s Subchapter V designation under the particular facts of the case. See In re National Small Business Alliance, Inc., 2022 WL 2347699 (Case No. 21-0003) *1 (Bankr. D.C. June 29, 2022).

The debtor in National Small Business Alliance had 700 to 750 members who paid dues for the debtor’s referrals and marketing assistance for the members’ small businesses. Id. at *1. Saddled with litigation, the debtor filed bankruptcy and designated itself as a small business debtor under Subchapter V. Id. Due to various litigation issues and the fact that the debtor’s management was ultimately dispossessed under Section 1185 of the Bankruptcy Code, the debtor was not timely in filing its plan. Id. The debtor then filed four amendments to the plan, and in the face of multiple objections, Judge Gunn denied confirmation of the fifth amended plan. Id. Although the parties focused on dismissal and conversion to Chapter 7, Judge Gunn determined that conversion was not an option, and that dismissal was not in the best interests of creditors and the debtor’s members. Id. at *2 and *4. Instead, Judge Gunn held that the bankruptcy court had the authority to revoke the debtor’s designation as a small business debtor and appoint a regular Chapter 11 trustee (in contrast to a Subchapter V trustee), and that doing so was warranted under the circumstances given the debtor’s inability to get a plan confirmed quickly and the dispossession of its management. Id. at *2.

In reaching that determination, the bankruptcy court first observed that the majority of courts have held that an eligible debtor cannot convert a traditional Chapter 11 case to a Subchapter V case, but must instead remain in Chapter 11 and amend their petition to elect to proceed under Subchapter V. Id. at *2. Thus, the bankruptcy court held that “[t]he converse is applicable in this case. The Court cannot order that the Debtor convert to ‘standard’ chapter 11, but instead must order that the Debtor’s petition be amended to revoke the election to proceed under Subchapter V.” Id. (citation omitted).

As far as authority for revocation, the bankruptcy court recognized that although Section 1185 of the Bankruptcy Code specifically provides for the dispossession of a debtor in possession while remaining in Subchapter V, nothing in Subchapter V explicitly addresses the bankruptcy court’s ability to revoke a debtor’s election to proceed under Subchapter V. Therefore, Judge Gunn looked to case law and the provisions of Bankruptcy Code as a whole. Id. Judge Gunn first reasoned that previous cases have held that “[i]f a petition may be amended to elect to proceed under Subchapter V post-petition, logically it follows that the opposite must also be an option for debtors and courts.” Judge Gunn then compared Sections 706, 1112, 1208, and 1307 of the Bankruptcy Code, which specifically allow conversion from one chapter to another if the debtor is an eligible debtor under such chapter, and held that the revocation of a Subchapter V election was consistent with those provisions and “the Congressional goals of ensuring that Subchapter V cases provide a quicker reorganization process,” because it would allow a debtor to avoid the delays and inefficiencies of a dismissal by continuing in a standard Chapter 11 proceeding. Id. at *3. The bankruptcy court noted that avoiding dismissal would also prevent:

1. unnecessary additional filing fees;
2. duplicative employment applications and first day pleadings;
3. complications related to lapses in the automatic stay;
4. relitigation of certain issues; and
5. the need for creditors to file duplicative proofs of claim. at *4 n. 3.

Finally, Judge Gunn held that Section 105 of the Bankruptcy Code provided additional statutory authority to carry out the provisions of the Bankruptcy Code. Id. at *3.

Key Takeaways

Subchapter V is a powerful tool for small businesses to reorganize in a more cost-effective manner without having to contend with some of the substantial hurdles to confirmation imposed by traditional Chapter 11 cases, such as the absolute priority rule and expedited payment of administrative expenses upon confirmation. Recent changes in the debt threshold have opened Subchapter V to a much broader range of companies until at least June 2024. Although the spirit of Judge Gunn’s decision appears to be focused on avoiding the inefficiencies and hardships of dismissal to the bankruptcy estate, there may be some unintended consequences. Recalcitrant creditors may seek to utilize National Small Business Alliance as a sword rather than a shield, and pursue the revocation of otherwise lawful Subchapter V elections in order to leverage the more strenuous economic requirements of a traditional Chapter 11 proceeding. But Subchapter V debtors can and should argue that National Small Business Alliance is limited to the facts of the case — material delays in the confirmation process in the context of the dispossession of management. Further, debtors should view National Small Business Alliance as a friendly reminder that although Subchapter V may create a clearer path to confirmation, they must be aware of, and (absent an extension by the court) comply with, the more stringent timing requirements, such as the requirement of filing a plan within 90 days after filing bankruptcy.