Small Business Bankruptcy During the COVID-19 Outbreak
Many small businesses throughout the U.S. have struggled to survive the challenges posed by the novel coronavirus. If a business is overwhelmed by debt, its owners may decide to file for bankruptcy. Businesses most often file for bankruptcy under Chapter 11 or Chapter 7 of the Bankruptcy Code. While Chapter 11 historically has proven more useful to large businesses, changes under recent federal laws may make it a good option for small businesses during the COVID-19 outbreak.
A standard filing under Chapter 11 involves agreeing with creditors on a proposed reorganization plan, which will be confirmed by a court if enough creditors accept it. This allows the business to continue operating, which would not be possible if the business filed for bankruptcy under Chapter 7. The seven largest unsecured creditors of the business will form a creditor committee to monitor the operations of the business and help develop the reorganization plan. The creditor committee process can become costly, since it may involve retaining attorneys and experts to investigate the business. Also, a reorganization plan may not be finalized for over a year after the debtor files, due to the complexities of negotiating with creditors. The cost and inefficiency of Chapter 11 thus have made it unattractive to many small business owners in the past.
Subchapter V of Chapter 11
Addressing these problems, the federal Small Business Reorganization Act of 2019 (SBRA) added a provision known as Subchapter V to Chapter 11. On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act expanded the range of Subchapter V to cover more small businesses. Through March 26, 2021, a business will qualify for Subchapter V if it has up to $7.5 million in non-contingent liquidated secured and unsecured debt. After that date, the debt ceiling will revert to the standard amount of $2,725,625. The Consolidated Appropriations Act of 2021 (CAA) did not extend this provision any later than March 26, 2021.
Bankruptcy under Subchapter V of Chapter 11 sometimes resembles a Chapter 13 bankruptcy. Subchapter V eliminates the creditor committee requirement in Chapter 11 and allows a bankruptcy trustee to monitor the debtor’s payments. Thus, the owners retain greater control over the business. Subchapter V also provides more efficient relief. A debtor submits their proposed reorganization plan within 90 days of filing for bankruptcy. It requires approval from a judge but not from creditors. A judge will approve a plan if it is fair and equitable, and if it seems at least reasonably likely to succeed. Often, a plan allocates the disposable income of the debtor toward repaying creditors over the next three to five years. To remain eligible for this relief, the business must keep up with plan payments during the applicable time.
These benefits come with certain specific requirements. For example, the business must submit a wide range of financial disclosures and reports throughout the process. The managers of the business must attend a series of meetings, including a debtor interview, a scheduling conference, and a Section 341 meeting of creditors. The business also must keep up with taxes and insurance, and it must allow inspections of its property, books, and records with reasonable notice.
Additional Protections Under the Consolidated Appropriations Act of 2021
The Consolidated Appropriations Act of 2021 (CAA) included additional amendments to the Bankruptcy Code in an attempt to make bankruptcy more equitable during the coronavirus pandemic.
The CAA allows small business debtors under the SBRA to request a 60-day extension to perform obligations arising under a lease of non-residential property, such as paying rent, if the debtor has experienced a material hardship due to COVID-19. This is in addition to the 60 days already afforded under section 365(d)(3) of the Bankruptcy Code. Debtors may also take 210 days, rather than 120 days, to decide whether to accept or reject non-residential property leases, with the option to extend this deadline by an additional 90 days with permission of the bankruptcy court.
The Bankruptcy Code typically allows debtors and trustees to recover payments made to any creditor within 90 days of a bankruptcy filing. However, the CAA amended this provision under section 547 of the Bankruptcy Code so that debtors and trustees may not claw back certain payments. To be protected from the claw back provision, these payments must have been made to a lessor of non-residential real estate or a supplier of goods or services under an agreement to defer or postpone payments entered into after March 12, 2020 as a result of the coronavirus pandemic. The payments also cannot exceed the amount due under the agreement as executed before March 12, 2020 and cannot include fees, penalties, or interest greater than those scheduled to be paid under the agreement. Thus, the CAA is intended to encourage parties to enter into flexible payment agreements without hindering a creditor’s rights during bankruptcy.
These provisions will be in effect until December 27, 2022.
The CARES Act did not address whether small business debtors were eligible for the Paycheck Protection Program (PPP), but the CAA since clarified that the Small Business Administration (SBA) may allow small business debtors to obtain PPP loans after bankruptcy. However, the SBA has not yet allowed the provision to take effect. Until it makes an affirmative statement to the contrary, small business debtors remain ineligible for PPP loans.
Filing Under Chapter 7
Sometimes a small business will file for bankruptcy under Chapter 7, although this chapter is more commonly associated with individual bankruptcy. After the business files, a bankruptcy trustee will liquidate its assets and distribute the proceeds among creditors. However, a Chapter 7 discharge is not available to businesses that have shut down already. Most small businesses that have closed because of the COVID-19 outbreak thus will not qualify for this form of relief.
Chapter 7 may be more attractive to sole proprietors than other business owners. This is because sole proprietors who file under Chapter 7 can receive a discharge for personal debt as well as business debt. Thus, they can greatly reduce their overall debt burden and rebound more quickly from the COVID-19 outbreak. A sole proprietor with a service-oriented operation may even be able to keep the business open by relying on their own labor, while the bankruptcy trustee sells the assets of the business. However, the bankruptcy trustee has the discretion to decide whether a business can stay open in these circumstances. A trustee sometimes may allow a business to stay open if it has liability insurance, or a trustee may not allow a business to stay open at all.
Many business owners may find it simpler to shut down the business and then file for Chapter 7 bankruptcy as an individual. This normally involves passing a means test, which may seem unlikely if your business was profitable before the COVID-19 outbreak. You do not need to pass the means test, though, if your business debt exceeds your personal debt.