In August of 2019, the President signed into law the Small Business Reorganization Act (“SBRA”).  SBRA created a new Subchapter V of Chapter 11 of the United States Bankruptcy Code effective February 19, 2020.  SBRA is intended to make it easier and less expensive for small businesses to reorganize under Chapter 11.  As enacted, SBRA defined a small business debtor as a person or entity “engaged in commercial or business activity” that owed aggregate secured and unsecured debts, excluding debts to insiders and affiliates, of $2,725,625 or less, of which at least 50% of such debts must have resulted from the commercial or business activity.  In response to the COVID-19 pandemic, the Coronavirus Aid, Relief and Economic Security Act (“CARES”) amended SBRA to increase the amount that a debtor may owe and still be eligible to proceed under Subchapter V to $7.5 million for a period of one year beginning on March 27, 2020.

SBRA was expected to trigger a surge of bankruptcy filings before the COVID-19 pandemic was on the horizon simply because it eliminated many of the impediments to reorganization in a traditional Chapter 11 case.  The economic effects of the COVID-19 pandemic on businesses throughout the country, coupled with the CARES amendment making larger businesses eligible for relief under Subchapter V, are now expected to trigger an even larger surge of filings under Subchapter V.

SBRA contains a number of terms that are not defined in SBRA itself or anywhere else in the Bankruptcy Code.  The meanings of these terms will be established over time by decisions of bankruptcy and appellate courts.  Consequently, it is helpful to look at the cases interpreting SBRA during the first three months of its existence to prepare for the probable coming storm.

Eligibility to Seek Relief Under Subchapter V

According to a survey of cases reported in Westlaw, the most litigated issue under SBRA to date is whether a debtor who had filed a case under Chapter 11 or another Chapter of the Bankruptcy Code before February 19, 2020 may elect to proceed under Subchapter V.  Bankruptcy courts in California, Michigan, New York, North Carolina, and Pennsylvania have allowed debtors whose cases were pending before February 19, 2020 and who could not have taken advantage of the rights afforded by SBRA when their cases were filed to elect to proceed under Subchapter V.  These is no case reported in Westlaw in which a court has held that only a debtor whose case was filed on or after February 19, 2020 may proceed under Subchapter V.

The cases reported to date have all involved debtors who filed for bankruptcy before February 19, 2020 owing less than $2,725,625 and then sought to proceed under Subchapter V.  However, there is nothing in the analysis of the courts in those cases or in CARES that would prevent a debtor who owes $7.5 million or less and who filed for bankruptcy before February 19, 2020, or even who filed on or after February 19, 2020 but before March 27, 2020, from electing to proceed under Subchapter V now.

Neither SBRA nor the Bankruptcy Code defines “commercial or business activity.”  Early indications are that bankruptcy courts will be liberal in interpreting the requirement that a debtor must be engaged in such activity to qualify as a small business debtor.  In a South Carolina case, the debtor was the sole member of a limited liability company and the owner of 49% of the stock of a corporation.  Both of those businesses had failed before the debtor filed for bankruptcy and were no longer operating.  The debtor himself was not engaged in any business.  Yet the court determined that he was engaged in a commercial or business activity because he was “addressing residual business debt” left by the failed businesses and those debts accounted for more than 50% of the debtor’s total outstanding debts.

In a California case, a secured creditor objected to a debtor being allowed to proceed under Subchapter V on the grounds that at least 50% of her debts did not result from commercial or business activities.  The secured creditor’s loan accounted for more than 50% of the debtor’s debts and the proceeds of the loan had been used to purchase the debtor’s residence in which she started operating a bread and breakfast “within the first year” after the property was purchased.  The court found that the debt to the secured creditor resulted from a commercial or business activity because the debtor planned to operate a bed and breakfast in her residence when she purchased it even though she did not start operating it as such until later.

Greater Rights Afforded Debtors Under SBRA

It is evident from simply reading SBRA that it makes it much easier for a debtor to achieve confirmation of a loan than it is in a traditional Chapter 11 case.  Any bankruptcy practitioner understands the significance of being able to confirm a plan that impairs classes of claims without having to obtain acceptance by any impaired class or, for that matter, being able to confirm a plan without having to obtain acceptance by any class.  However, the way those differences have played out in real cases shows how dramatic the changes effected by SBRA are.

For example, in a Pennsylvania case, the automatic stay had been lifted as to two of the Chapter 11 debtor’s business locations, the court had ordered the debtor to file a plan and disclosure statement, and the debtor’s secured lender had moved for appointment of a Chapter 11 trustee.  The debtor then moved to proceed under Subchapter V.  The secured lender objected because a Subchapter V trustee does not obtain control of a debtor’s assets or have the ability to file a plan like a trustee in a traditional Chapter 11 case, but simply advises the debtor and processes payments under a confirmed plan.  The court allowed the debtor to proceed under Subchapter V.

In a California case, the debtor operated a bread and breakfast in her residence.  The court had found her Chapter 11 plan to be “patently unconfirmable” because it sought to modify a claim secured by her primary residence and had allowed the secured creditor to file a proposed plan which was awaiting confirmation.  The debtor then moved to proceed under Subchapter V.  The secured creditor objected because creditors are not allowed to file plans in Subchapter V cases and because the debtor sought to modify its secured claim in her Subchapter V plan in the same way that had rendered her prior Chapter 11 plan patently unconfirmable.

The debtor’s traditional Chapter 11 plan was unconfirmable because of Bankruptcy Code Section 1123(b)(5) which provides that a plan filed by an individual debtor may not modify the rights of the holder of a claim “secured only by a security interest in real property that is the debtor’s principal residence.”  SBRA, however, provides;

Notwithstanding section 1123(b)(5) of this title, [a plan] may modify the rights of the holder of a claim secured only by a security interest in real property that is the principal residence of the debtor if the new value received in connection with the granting of the security interest was—

(A) not used primarily to acquire the real property; and

(B) used primarily in connection with the small business of the debtor.

The secured creditor argued that because the proceeds of its loan had been used to purchase the property in which the debtor lived and operated a bread and breakfast, new value had been used primarily to acquire the property and the debtor could not modify its rights in a Subchapter V plan either.

The court overruled the secured creditor’s objection and permitted the debtor to proceed under Subchapter V. The court said that the language quoted above directs “the Court to conduct a qualitative analysis to determine whether the principal purpose of the debt was not to provide the debtor with a place to live.”  Since the debtor incurred the debt with the intention to operate a bread and breakfast in the property purchased with the proceeds, the court concluded that the debt was not incurred primarily to acquire a residence even though the property was her residence.

Conclusion

The cases decided to date reflect liberal interpretation of SBRA in favor of debtors.  As the world moves forward reeling under the economic effects of the COVID-19 pandemic, courts are likely to continue to interpret SBRA so as to maximize the ability of debtors to achieve confirmation of reorganization plans.