The Small Business Reorganization Act of 2019 and COVID-19

Professor Ted Janger of Brooklyn Law School sent me a proposal for a small change to the Bankruptcy Code that might significantly help small businesses affected by the COVID-19 pandemic. His idea merits consideration. In Ted’s words:

Obviously, it is too early to tell how all of this will play out, but the U.S. bankruptcy system will inevitably play an important role in whether small businesses hurt by COVID-19 ultimately survive. Chapter 11 was built to help sound businesses that experience a sudden shock, but it is often too cumbersome for even medium-sized businesses. In a law that took effect in February, Congress made it easier for small businesses to benefit from chapter 11. That law is only available, however, to businesses with less than $2.7 million in debt. It will, therefore, apply to only 42% of the businesses that file. In the wake of COVID-19, Congress should raise the debt ceiling to $10 million to help more small businesses and soften the inevitable fallout that will come from COVID-19 related business disruptions.

COVID-19 bankruptcies are likely to be different from the most recent crop of media and manufacturing bankruptcies. In those cases, the industry or core business model is in transition. Fixing those businesses is complicated. COVID-19 bankruptcies will be simpler. They will result from a temporary but brutal cash flow hit on otherwise viable businesses. This is precisely the situation Chapter 11 handles best – recapitalization of a viable, but financially distressed business.

A typical Chapter 11 gives the debtor a bit of breathing space and provides mechanisms to facilitate a mostly consensual restructuring. Where agreement cannot be reached, it offers the possibility of non-consensual confirmation based on statutory entitlements. Unfortunately, for most small- or even medium-sized businesses likely to be affected by COVID-19 the process is too expensive to be useful. The cost of committees, multiple hearings, and so on, would eat through any available enterprise value.

By fortuitous happenstance, on February 19, Congress provided an important tool to address COVID-19 disruption. The Small Business Reorganization Act of 2019 (SBRA) creates a new, streamlined procedure to restructure the debt of small business. The first cases under the SBRA are only just being filed, but that is likely to change.

First, and most importantly, the SBRA contains an “off the shelf” path for the owners to redeem the business from creditors. So long as the secured creditors are paid the value of their collateral (over time), and the debtor commits all of the “disposable income” of the business to the creditors for three to five years, the debtor can retain ownership of the business. In other words, for many businesses, the SBRA will allow them to hit the reset button and return to productivity with a sustainable amount of debt.

Second, the SBRA streamlines the path to reorganization. The debtor is given a short time to propose a plan (90 days), extendable only if the court approves. The disclosure statement and plan are combined in one document and approved or disapproved at the confirmation hearing. In large corporate bankruptcies, by contrast, this process can be quite lengthy and expensive.

These are powerful tools, and without proper supervision, they might be subject to abuse. However, third, the SBRA contemplates a novel type of trustee. The SBRA trustee does not displace the existing owner/managers, but instead, works alongside them. The first job of this trustee will be to evaluate the business and determine whether it is sensible to continue. If no, the next step will be to liquidate. But for businesses affected by COVID-19, the problem is likely to be debt overhang caused by a temporary business disruption. In those cases, the job of the trustee will be to help the debtor develop a financial plan, and to earn the trust of the creditors and the confidence of the court.

Unfortunately, the $2.7 million debt limit will severely limit the role that the new procedure will play in any post-pandemic recovery. Many companies with between $2.7 million and $10 million in debt will still be unable to make effective use of traditional Chapter 11 but would benefit from a proceeding under the SBRA.

Indeed, Congress modeled the SBRA on Chapter 12 of the Bankruptcy Code which has been used successfully, for years, to restructure the debts of family farmers with debts (now) up to $10 million. Prior to enactment of the SBRA, both the National Bankruptcy Conference and the American Bankruptcy Institute recommended a small-business threshold comparable to that for family farmers. This made sense before, and it makes even more sense now.

In sum, the new SBRA procedure should provide an important and timely tool in addressing the transitory dislocation caused by various types of financial crisis. Given the likely need for short-term restructuring of COVID-19 created debt, across the economy, it might be prudent to consider emergency legislation to increase the eligibility threshold to $10 million.

I (Bob) reran the numbers from my original blog post calculating how many cases the new law would cover. A $10 million threshold will raise eligibility from 42% to 59% of all cases. Some may see that as a modest gain, but every case represents a struggling small business and a chance to save the business for the employees who work there. Congress might even consider a temporary increase that is even higher until the crisis passes.

Comments

[Christian Onsager]

The faster track of Subchapter 5 may be a larger problem. 90 days may be far too short a time in this market before we return to enough normalcy to allow predictability about future performance of any business. Until then, feasibility of any plan is more of a wild-assed guess than it usually is. So I am not sure that the primary need will be for restructuring short term Covid-19 debt. The bigger issue is that many businesses cannot survive long enough to get to a restructuring given the drastic drop in revenue, and subchapter 5 won't solve the basic economic problem.

[Robert S. Thomas, II]

A lot of factors will determine if small businesses and individuals can pull threw this period of time. Just about every sector of our economy is going to be impacted.

I agree, cash flow for small business or a life-line will be critical along with getting clients or customers back. In order to help more individuals, and self employed individuals congress should raise the chapter 13 debt limits so more individuals can gain access to a proven flexible repayment plan.