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The Disappearing Small Businesses (Designation) in Bankruptcy

posted by Bob Lawless

The 2005 bankruptcy law was not just about consumers. It made a number of changes to businesses bankruptcies, including the expansion of safe harbors for derivative claimants about which Stephen Lubben has written extensively (e.g., here). Other changes were to small business bankruptcies--not to make it easier for small businesses to get through chapter 11 but to make it more difficult. Small business bankruptcy filers got new duties and extensive new reporting requirements, both of which can lead to dismissal for debtors who fail to meet them. As I was preparing to teach these requirements this year, I came across a little surprise about the difference between this law on the books and the law on the ground that I thought I would share.

As I wrote a few years ago:

In addition to Mom and apple pie, there was always at least one other subject that members of Congress would support and that was small business. The 2005 bankruptcy law, however, was affirmatively hostile to small business, making it more difficult for small businesses and their owners to get bankruptcy relief. Although Congress passes many laws that advantage large business and often at the expense of the large businesses’ smaller counterparts, the 2005 bankruptcy law is the only example of which this author knows that expressly singles out small business for harsher treatment than a similar large business. Perhaps Mom and apple pie need to hire a lobbyist to prevent the same from happening to them.

("Small Business and the 2005 Bankruptcy Law: Should Mom & Apple Pie Be Worried?," 31 S. Illinois. Univ. L.J. 585 (2007)).

Congress designated a "small business debtor" as any debtor with less than $2,190,000 in total secured and unsecured debts and for which there is no active creditors' committee. (There are more details such as the requirement that the debts be noncontingent and liquidated and that the limits gets inflation adjusted every three years.)

To get a handle on how exactly how many chapter 11 cases each year meet this definition, I pulled down the 2007 bankruptcy petition integrated database, and what I found just did not seem right. According to these data, there were 2,299 chapter 11s filed in 2007 where (i) the debtor was not an individual, (ii) said they had predominately business debts, and (iii) where the total liabilities were between $50,000 and $1,000,000. Because very few small chapter 11 cases have creditors' committees, almost every one of these 2,299 cases should have identified as small business debtor, but only 36.8% did so. I pulled the docket on one of the cases, and it was a manufacturer that said it had about $800,000 in debt and yet did not identify as a small-business debtor.

In theory, the small-business provisions of chapter 11 are self-executing, but I suspect in practice they often are not. If a debtor does not designate as a small business, it might fly under the radar and avoid having to meet the new reporting requirements. One practitioner suggested to me that that the reason for the low compliance rate was inattentiveness: the software the attorneys used to complete the forms did not adequately draw their attention to the small-business box. Other practitioners pointed out that the definition requires that no creditors committee is active, and the appointment of a committee is up to the U.S. Trustee. Thus, until the U.S. Trustee files a notice that it will not appoint a committee in a case, it is not a small business case. Whatever the reason, the low rate of small-business designations is another example of how "law on the ground" often adapts and changes the "law on the books."


Business Chapter 7's, even liquidating 7's are much more difficult to get approved as well. Makes no sense to me. As AMC mention before they should be treated better and allowed to discharge debts easier than a typical 7 debtor. Even though these types of debtors are exempt from the means test in 7 (I know we are talking 11's here) they are grilled relentlessly at 341 by the UST. We do quite a few small biz bks (none of them are 11s) especially lately and they are dragged through hell and back by the UST...we of course have to charge accordingly. The UST increases the costs to debtors. The only reason I mention 7s is that even though we do quite a few biz bks we never file 11s. Individuals I believe can file those "baby" 11s also. The expenses in 11s are substantially more than liquidating in 7. There are of course other reasons to elect liquidating in 11 over 7 I assume.

The "rocket docket" for small business Chapter 11s was a practice instituted by some bankruptcy judge back in the early 1990s. Maybe earlier.

Like many "creative" bankruptcy practices, the local bar "loved it". Meaning, they went along with what their local bankruptcy judge required. And they said nice things about what he required them to do in small 11s. I mean, wouldn't you if you practiced before him?

The small business Chapter 11 practice was seen as a good thing, based on the 'experience' of this one court. The big benefit was that you could have one proceeding on the disclosure statement and the Plan. Whoopty-do. You also have to work out all the many problems associated with a Chapter 11 in a very compressed time frame or you are out on your assets.

In reality, the small business Chapter 11 provision is - as you point out - a bad thing for small businesses. Chapter 11 practitioners who don't have to worry about being honest about what they really think - because they aren't talking to the guy who invented the procedures - have given the small business Chapter 11 provisions of BAPCPA a pretty universal thumbs down.

And lots of bankruptcy judges - who are "fixers" of the Code, not strict interpreters of the Code - aren't going to enforce provisions making small Chapter 11s harder, unless a party in interest raises the issue. They want these small business Chapter 11s to actually work.

God only knows what Congress wanted.

To AMC: I think you're referring to Judge Thomas Small's procedure that he used in the Bankruptcy Court for the Eastern District of North Carolina. What ended up as the small-business provisions of the 2005 amendments were an extremely pale imitation of Judge Small's procedures. Where Judge Small had a procedure that emphasized flexibility and tried to help business through chapter 11, the 2005 amendments have rigid rules and multiple avenues for dismissal.

From what I had heard, the actual enthusiasm for Judge Small's procedures was significantly less than the perceived enthusiasm.

Every judge who is an 'innovator' needs to keep in mind that the feedback he or she is getting on what was done is not necessarily uninfluenced by who they are.

The majority of attorneys publicly support their judge's procedures. Just a fact of life in the practice.

One other thing - the "rocket docket" provisions were actually enacted in 1994, not 2005. Sections 1121(e) and 1125(f) made the small business track elective - you could choose it if you wanted it.

It was a long time ago, but my recollection is that virtually no eligible business elected the small business track - it was not regarded as beneficial. The deadlines were too short, and the 'benefits" were not that beneficial.

What BAPCPA did was make the small business track mandatory, and harden the deadlines. But BAPCPA was not the original implementation of the 'rocket docket' - it was the 1994 Amendments. See, 140 Cong. Rec. H 10,768 (October 4, 1994).

The 1994 Amendments had flexibility for small businesses but (check your small business statistics pre-BAPCPA, my memory could be faulty) almost no one (outside of Judge Small's district) made the small business election.

The 1994 amendments were the original small-business provisions. It was an election that offered few benefits, a tight time deadline, and almost no one elected it. I used to tell my students it was close to malpractice per se to make this election.

I think we'd both quibble with the characterization of the 1994 amendments being the original implementation of what ended up in BAPCPA. True, there is some overlap. But, it's akin to calling The Beatles the original implementation of what ended up being Paul McCartney & Wings.

The bottom line - whether it was the 1994 Amendments that directly mirrored Judge Small's procedures, or the mandatory provisions of BAPCPA: nobody liked them.

There was an assumption that something really good was going on with this "rocket docket". But it was really just debtor's counsel going along to get along.

I think this is an important problem to consider in having new practices "filter up" from a local experiment to either a Code provision or a Rule. Was it really a better mouse trap, or was it that everyone wanted to get along with the vendor of the new mousetrap?

Another structural legislative problem this small business Chapter 11 situation illustrates - when Congress wants something to work, they try to force debtors to make the choice they want, INSTEAD OF GIVING DEBTORS AN INCENTIVE SO THAT THEY WANT TO MAKE THAT CHOICE.

Quicker small business Chapter 11s are only one example of this wrong-headed approach. Chapter 13 is where Congress wants consumer debtors to go. But, they have whittled away many of Chapter 13's advantages - the old "super discharge" is now barely better than a Chapter 7 discharge. The ability to look at a budget realistically has been gutted by grafting 707(b)'s Means Test into Chapter 13. And the ability to bifurcate car loans has been severely restricted. The statistics on Chapter 13 filings reflect what happens when you reduce the Chapter 13 carrots - you get proportionally less Chapter 13 debtors.

Then Congress blames debtor's counsel for not falling into line and doing what the legislation tried to force debtors to do. It isn't the fault of the attorneys - it is the fault of Congress. For debtors Congress passes "reforms" that are all stick and no carrots. But for creditors, on issues like mortgage modification, it is all carrot and no stick. Then, after screwing things up for a decade, they will argue why each approach didn't work.

The reason neither approach will work is because you need both: Carrots, and sticks. If Congress is unwilling to legislate both real carrots and real sticks - for both debtors and creditors - they are going to continue revisiting the Code, wondering why bankruptcy just "doesn't work".

...right on the money AMC! I think its slowing our recovery. If congress wants real and tangible results in Mortgage Modifications, increase consumer spending then we need a larger pool of consumers. Not debtors. The only way to do it is if we reform BK reform. Can anyone think of a more opportune time in our history? Now is the time we need it. Actually it would have been better to have it already a year ago. We would have had a valuable tool in dealing with our current crisis and it would have lessened the effects on all of us down here at the bottom of the trickle down.

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