How Many New Small Business Chapter 11s?

The Small Business Reorganization Act of 2019 adds a new subchapter V to chapter 11 for small businesses. The new subchapter gives small businesses the option of choosing a more streamlined -- and hence cheaper and quicker -- procedure than they would find in a regular chapter 11. Perhaps most significantly, the absolute priority rule, which requires creditors to be paid in full before owners retain their interests, does not apply. For those interested in more detail, the Bradley law firm has a good blog post summarizing the key points of the new law, which takes effect in February 2020 (and if I have the math correct -- February 19 to be exact).

A point of discussion has been how many cases will qualify to be a small-business chapter 11. Using the Federal Judicial Center's Integrated Bankruptcy Petition Database, my calculation is that around 42% of cases filed since October 1, 2007, would have qualified. The rest of this post will explain how I came to that estimate as well as discuss year-to-year variations and chapter 11 filings by individuals.

In setting out which cases can use the new procedure, the law builds on the existing definition of a small-business case in section 101(51D) of the Bankruptcy Code with some amendments. Under the new law, a debtor can choose to be a small-business case if:

1. The debtor is engaged in commercial or business activities other than a single-asset real estate debtor;
2. The total liabilities (owed to noninsiders and nonaffiliates) are less than the statutory threshold, which currently stands at $2,725,625 but is inflation adjusted every three years;
3. At least 50 percent of the liabilities arose from commercial or business activities; and
4. The debtor is not a member of an affiliated group of debtors (e.g., a corporate group) who debts together exceed the statutory threshold.

Fortunately, all of these variables or reasonable proxies for them are in the FJC's database. Using data entered by the court clerk and then assembled by the Administrative Office of U.S. Courts (AO), the FJC database has an entry for each bankruptcy case filed in the 2008 - 2018 fiscal years. If it was pending for more than one year, a case can appear in the database more than once so I eliminated all duplicate entries. Oddly, 26.7% of all cases have zero liabilities. The codebook indicates these are missing values, presumably from cases that got filed without schedules and never got updated in the AO's database. Without any information on these cases, I eliminated them from the analysis. If I use these cases and treat them as "true zeroes" (which they obviously are not), the estimates of the percentage of chapter 11's that will qualify as a small-business case increases by about ten percentage points.

Across all eleven years of the database, 58.4% of the chapter 11's fall under the statutory debt threshold in effect at the time, but then we have to eliminate cases that do not meet the other criteria. Debtors engaged in primary commercial or business activities with at least 50% of their debt from those activities are determined by the bankruptcy petition checkbox of whether the debtor has "primarily" business or consumer debts. Single-asset real estate cases are identified by the question on the bankruptcy petition about the nature of the debtor's business. Debtors who are members of an affiliated group are identified by whether the case was jointly administered with the affiliated group being counted only as one case with total liabilities measured as the sum of the group's liabilities. Just under 20% of the chapter 11's were part of an affiliated group.

After eliminating debtors that do meet these other criteria, 39.8% of the 71,463 chapter 11's in all eleven years of the database would have qualified as a small-business case. But, there is some variation across the years with a range of 36.5% to 43.5%:

2008 -- 41.5% 
2009 -- 38.9% 
2010 -- 36.5%
2011 -- 37.1%
2012 -- 38.5%
2013 -- 40.9%
2014 -- 43.5%
2015 -- 41.7%
2016 -- 42.8%
2017 -- 41.4%
2018 -- 41.1%

More recent experience should be a better indication of what to expect, and the last five years averaged 42.2%. Hence, my estimate is that around 42% of the chapter 11's will qualify. With chapter 11 filings running around 5,500 to 6,000 filings per year, past experience suggests around 2,300 to 2,500 small-business filings each year. (Note my number of chapter 11 filings does not match up with the number of chapter 11 filings reported by the AO because I am counting affiliated groups as only one filing.)

That estimate, however, is likely a low end. The calculation uses information gathered primarily for statistical purposes. With the availability of broader relief under new subchapter V, debtors will have much more incentive to complete that information in a way that indicates they qualify as a small business. Also, one would expect that some businesses that stayed away from bankruptcy will now file chapter 11. On other hand, the new subchapter requires an election, and some debtors might not make it. Given the benefits of the new chapter, I would expect most every eligible debtor will make the election, although perhaps the downside of having a trustee will deter debtors from making a small-business election.

Individual chapter 11 debtors who meet the criteria can also make a small-business election, and a big lure of the subchapter is that it clearly eliminates the absolute priority rule. In 2010, then-Judge Bruce Markell wrote an insightful (and, in my opinion, correct) decision holding the absolute priority rule did not apply in an individual's chapter 11 case. See In re Shat, 424 B.R. 854 (Bankr. D. Nev. 2010). Despite the erudition on display, most every court that has considered the issue since then has held otherwise. Thus, I wanted to separately look at the subset of chapter 11 cases filed by individuals.

There has been an average of 2,276 individual chapter 11 cases for the eleven years of the database, and the number of individual cases that would have qualified for the small-business election has been right at 25%. Again, my calculations for whether a debtor has a majority of business debts is the checkbox on the bankruptcy petition for whether the debts are primarily consumer or business debts. That language on the form is similar but not identical to the language in the new statutory definition. And, again, the checkbox on the petition is collected for statistical reasons. I expect to see individuals more aggressively claim that certain debts are of a business nature such that the past data may be a low estimate of the percentage of individual chapter 11 cases that elect small-business status.

The bottom line is that a lot, but not a majority, of chapter 11's will qualify for the new small-business subchapter. Given the percentages, the new subchapter will hardly be a small niche of the bankruptcy world. Practitioners (and teachers) of bankruptcy law need to become familiar with its provisions.

Comments

[Bashar H. Malkawi]

The non-applicability of the absolute priority rule is very important aspect of the law. This will give a breathing room for the small business debtor who does not need to worry about payments from the start.

Bashar H. Malkawi

[Drew]

Thank you for writing an article with data. It will help every reader to get some important information about legal business policies. I am your regular reader and always get something new on your site. Keep it up!!

[Sally McDonald Henry]

This is extremely helpful and interesting!