There can be no mistake that small businesses represent the backbone of the Missouri economy. According to the Small Business Administration’s 2022 Small Business Profile, there are approximately 542,700 small businesses in the State of Missouri, which represents 99.4% of all Missouri businesses. The COVID-19 pandemic posed an existential threat to most small businesses.

In response, several governmental programs were enacted to help keep small businesses afloat. As these programs sunset and the country enters into a time of rising interest rates and continued inflationary pressures, the financial health of small businesses continues to be at risk. Many businesses may have no other choice but to consider bankruptcy relief if they want to keep their doors open. In particular, many small businesses may elect Subchapter V bankruptcy treatment.

Subchapter V Bankruptcy

In February 2020, the Small Business Reorganization Act of 2019 became effective. As part of this Act, Congress created Subchapter V, which alters the rules of a traditional Chapter 11 bankruptcy. Subchapter V was designed to make bankruptcy restructuring more feasible and affordable for small businesses.

Subchapter V is only available to a “Small Business Debtor.” A “Small Business Debtor” is a defined term under the Bankruptcy Code. Corporations, limited liability companies, partnerships and sole proprietorships can elect to Subchapter V treatment, provided that 50% or more of the entity’s debt comes from business or commercial activities. A single asset real estate entity in addition to public companies and their affiliates do not qualify for Subchapter V treatment. Currently, the breadth of Subchapter V eligibility is being tested with several lower courts taking differing positions on the same.

In its pre-pandemic form, Subchapter V had limited utility because it was available only to those debtors that owed less than $2,725,625 in non-contingent, liquidated, business-related debts. In response to the pandemic, the debt limitation was increased to $7,500,000, making it more widely available. This higher debt limit is currently set to sunset on June 21, 2024.

A Lender Playbook Change

Prior to Subchapter V being created, financial restructuring through a traditional Chapter 11 was cost-prohibitive for small businesses. A business would have to propose its plan of reorganization or liquidation and then generally engage in an expensive and lengthy process to get that plan approved by the bankruptcy court. Many small businesses did not have the financial wherewithal to make it through such an arduous process. Thus, many Chapter 11 cases resulted in the immediate sale of the debtor’s assets and, in some cases, the shuttering of the business. Subchapter V eliminates many of these barriers and moves at a rapid rate.

Subchapter V, however, changes the playbook on how a lender should approach a bankruptcy case. For instance, a bankruptcy plan is going to be generally filed within 90 days of the petition date and eliminates the “disclosure statement” stage of the case. This means plan approval will come much faster in a Subchapter V case.

In addition to the increased speed, Subchapter V eliminates several requirements that provided negotiating leverage to creditors in the planning process. In particular, Subchapter V eliminates the “absolute priority rule” and the requirement of an “impaired accepting class.” Stated simply, the absolute priority rule provides that, unless unsecured creditors are paid in full, holders of equity interests may not receive or retain anything under the plan. Requiring strict compliance with the absolute priority rule provides creditors with a substantial amount of leverage in plan negotiations.

Further, in a traditional Chapter 11 case, the debtor must get at least one class of non-insider creditors to vote in favor of their plan. In some cases, debtors would get creative in forming this impaired accepting class and there would be substantial litigation as to whether this creativity constituted improper “gerrymandering.” In Subchapter V, the debtor can confirm a plan even if all creditors vote “no” if certain other requirements are met.

In short, Subchapter V makes it easier for the small business debtor to “cram down” a plan on its creditors. Accordingly, lenders must be prepared to act fast and re-examine existing (even if seldom used) provisions of the Bankruptcy Code to either reclaim leverage in plan negotiations and/or prevent the confirmation of an unacceptable plan. Further, a lender should be prepared to work with its borrower and the newly created Subchapter V trustee to see if a consensual plan may be reached.

Conclusion

Subchapter V is designed to be fast-moving and supportive of a debtor’s reorganizational efforts. Lenders should be careful not to sit back and “wait and see” what happens but should be prepared to work proactively in order to secure their rights and treatment. Failure to do so may result in a loss of negotiating leverage and/or an unacceptable modification of the loan being “crammed down” upon the lender.