Say you are a small business and overwhelmed with debt. Your assets are hocked and your cash flow doesn’t cover your monthly obligations. Sure, you’ve made some mistakes, but you’re an honest debtor and just need a fresh start.
If your debts are less than $7.5 million, there’s good news. Under the newly enacted Small Business Reorganization Act, businesses or individuals in business with debts of $7.5 million or less can reorganize under a streamlined process that keeps them in control of their business and gives them a fresh start by simply committing to pay creditors an amount equal to the projected disposable income of the business over the next 3 to 5 years.
By way of background, since its enactment in 1979, chapter 11 of the United States Bankruptcy Code has established the rules by which a business can get a fresh-start and reorganize as a going concern. Chapter 11’s rules, however, were not designed with small businesses in mind. Chapter 11’s “absolute priority rule,” for example, prevents business owners from retaining their equity interests through a chapter 11 reorganization plan if unsecured creditors vote to reject the plan and are not paid in full. Also, to be confirmed, a chapter 11 plan must be accepted by at least one class of similarly-situated creditors. Further, the professional fees of a statutorily-mandated “Committee of Unsecured Creditors” can run as high as 50% of those charged by the debtor’s own professionals and must be paid in full as a condition to exiting chapter 11 unless some alternative arrangement is agreed to by the professional.
These obstacles to a small business debtor’s ability to successfully reorganize under chapter 11 were so formidable that small business owners facing state law collection proceedings could not feasibly reorganize. As a result, small business owners had no alternative but to terminate their workforce, liquidate their business, and rebuild from scratch.
To promote small business reorganizations and protect the workforces they represent, Congress enacted the Small Business Reorganization Act of 2019. This law created a new “Subchapter V” to chapter 11 that dispensed with the more creditor-friendly rules discussed above. As a result, as long as the aggregate payments to creditors under the small business debtor’s Subchapter V reorganization plan exceed the liquidation value of the business, the owner of the small business debtor can retain its equity in the business as long as it pays creditors an amount equal to the “projected disposable income” of the business over a 3-5 year period. Also, in lieu of an adversarial committee that runs up fees, an independent “Subchapter V Trustee” is appointed to facilitate the debtor’s reorganization at significantly reduced cost.
Significantly, if the reorganized small business debtor generates more net income than originally projected in the confirmed plan, those excess funds go to the business and need not be distributed to creditors. And while the chapter 11 protections to secured creditors are generally unaffected by this new law, one important change is that any mortgage on the debtor’s principal residence may be stripped down to fair value if the loan proceeds from that mortgage were used primarily in the business.
The new law has proven highly effective in helping small businesses successfully reorganize. The 1,426 Subchapter V small business cases filed in 2021 represented 30% of all chapter 11 business filings and one-quarter of these cases were filed by individuals whose majority of debts are business-related. Subchapter V is suitable for a broad range of operating businesses. So-called “single asset real estate debtors,” however, are ineligible for Subchapter V.
When first enacted in 2019, the debt limit for Subchapter V eligibility was only $2,725,625. That limit was increased under the CARES Act and the COVID-19 Bankruptcy Relief Act of 2021 to $7.5 million, but that increased limit expired on March 27, 2022 and reverted back to its original amount. Following intense lobbying of Congress, spearheaded by the American Bankruptcy Institute, the Bankruptcy Threshold Adjustment and Technical Corrections Act was signed into law on June 21, 2022, which again raised the debt limit to $7.5 million for bankruptcy cases filed through June 21, 2024. Absent further Congressional action, the Subchapter V debt eligibility limit will again revert back to the original $2,725,625 amount.