Subchapter V Bankruptcy for Middle Market Debtors
New York Law Journal
September 17, 2021
What is the “middle market”? Typically, this segment of the U.S. economy is defined as businesses with annual revenues roughly in the range of $10 million to $1 billion. Collectively, they are an economic powerhouse: According to the National Center for the Middle Market, there are about 200,000 such businesses in the United States, with annual combined revenues exceeding $10 trillion. Of course, these businesses—larger than the typical “mom and pop” shop, but most still privately owned or closely held—are not immune from financial distress, whether COVID-19-19-induced or otherwise, and at some point in the corporate life cycle may need to undergo financial restructurings, loan workouts, or bankruptcy proceedings. Unfortunately, the middle market has been particularly hard-hit by the rising costs of Chapter 11 bankruptcy in recent years, to the point that for some companies, it has paradoxically become too expensive to go bankrupt.
In response to broad criticism that Chapter 11 had become too expensive and complex for all but the largest companies, Congress enacted the Small Business Reorganization Act of 2019 (SBRA), which went into effect in February 2020. The SBRA added “Subchapter V,” 11 U.S.C. §§1181-95, to Chapter 11 of the Bankruptcy Code. Despite its formal name—the Small Business Reorganization Act—the statute colloquially known as “Subchapter V” may offer a streamlined reorganization vehicle for some middle market companies.
Subchapter V Benefits
Subchapter V was intended to provide eligible debtors with a more efficient, less costly, and simpler path to a Chapter 11 restructuring. Among its key features, Subchapter V (1) eliminates the official committee of unsecured creditors; (2) eliminates a debtor’s obligation to pay quarterly U.S. Trustee fees; (3) provides a reduced period (90 days) for the debtor (but no other party) to file a Chapter 11 plan; (4) permits a debtor to spread the payment of administrative expenses (including its attorneys’ fees and that of the Subchapter V trustee) over the life of its plan—which can stretch up to five years following plan confirmation—as opposed to having all administrative expenses due at confirmation; and (5) relaxes the “absolute priority rule,” which allows a debtor’s equity holders to retain their ownership interests in the debtor without an infusion of new capital or the payment of all creditors in full. Subchapter V also permits a debtor to confirm a plan of reorganization without accepting votes, because the debtor can “cramdown” a plan on all creditors without the approval of an impaired, consenting class of creditors. See 11 U.S.C. §1191(b).
The absence of a creditors committee is a particularly important cost-saving mechanism for middle market debtors. In “standard” Chapter 11 cases, Bankruptcy Code §1102 directs the Office of the United States Trustee (UST) to appoint a committee (charged with looking out for the interests of the debtor’s unsecured creditor body as a whole) as soon as practicable after the case is filed. Thus, a committee is formed in almost every Chapter 11 case (unless no creditors are willing to serve). The committee, in turn, is then entitled to retain its own counsel and other professionals, usually an accountant or financial advisor, as warranted. Because the debtor has to pay for all of the committee’s professional fees, the appointment of a committee can mean the addition of six- or seven-figures to the debtor’s overall cost of its bankruptcy case, even in relatively smaller cases. In Subchapter V, by contrast, no committee will be appointed absent cause, thereby greatly reducing the professional fees a debtor must pay to complete a Chapter 11 reorganization.
Likewise, the elimination of the “absolute priority rule” should make Chapter 11 restructuring more attractive for family-owned businesses by allowing owners to keep their equity interests without paying creditors in full, or making a “new value” contribution. This differs from “ordinary” Chapter 11, where any dissenting class of unsecured creditors must be paid in full before any junior class—such as equity interests—can receive or retain property under a plan. See §1129(b)(2)(B)(ii); Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 202 (1988). The only exception to such treatment is known as the “new value exception,” which permits a debtor’s equity holders to keep their ownership in exchange for putting additional cash into the company. Significantly, for many cash-strapped owners, the contribution of “sweat equity” does not qualify as “new value.” Norwest Bank, 485 U.S. at 202-06. Subchapter V, by contrast, allows such owners to remain in control following reorganization.
Who Is a Subchapter V Eligible Debtor?
The features discussed above make Subchapter V a very attractive option for debtors—if the company has debts under the statutory eligibility threshold. Who, then, is an “eligible debtor”? The standard is found in §1182 of the Bankruptcy Code, which provides in pertinent part, that for Subchapter V eligibility the term “debtor” means—
(A) subject to subparagraph (B) … a person engaged in commercial or business activities (including any affiliate of such person that is also a debtor under this title and excluding a person whose primary activity is the business of owning single asset real estate) that has aggregate noncontingent liquidated secured and unsecured debts as of the date of the filing of the petition or the date of the order for relief in an amount not more than $7,500,000 (excluding debts owed to 1 or more affiliates or insiders) not less than 50 percent of which arose from the commercial or business activities of the debtor; and
(B) does not include—
(i) any member of a group of affiliated debtors that has aggregate noncontingent liquidated secured and unsecured debts in an amount greater than $7,500,000 (excluding debt owed to one or more affiliates or insiders);
(ii) any debtor that is a corporation subject to the reporting requirements under section 13 or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m, 78o(d)); or
(iii) any debtor that is an affiliate of an issuer, as defined in section 3 of the Securities Exchange Act of 1934 (15 U.S.C. 78c).
11 U.S.C. §1182 (emphasis added). Of note, the SBRA’s original debt limit was only $2.7 million; Congress increased the limit to $7.5 million as a form of COVID-19 relief (which is currently set to expire on March 22, 2022).
While at first glance, the $7.5 million debt limit for Subchapter V eligibility may seem to eliminate most of the middle market, behind that figure are two important exceptions: insider debt and contingent debts, neither of which count toward calculation of the eligibility limit. The following hypothetical calculation demonstrates how a company with far more than $7.5 million in balance sheet liabilities can nevertheless qualify for Subchapter V:
Debtor A is a private equity-owned trucking company with estimated liabilities between $42 million and $44 million. It has a $3 million secured credit facility with Bank Z; a $25 million junior secured note to its parent company; a $4 million mortgage note on headquarters, also to its parent; $3.1 million debt to Banks Y and X, secured by trucks and trailers; and $1.1 million in unsecured trade debt. Additionally, Debtor A is subject to numerous tort claims related to motor vehicle accidents arising out of its trucking operations, with estimated liabilities of $6 million to $8 million. The parent is not publicly-traded, and owns two other portfolio companies: Affiliates B and C. Affiliate B has only insider debt. Affiliate C has no secured debt and trade debts of $250,000.
Debtor A is experiencing severe liquidity issues resulting from COVID-19-reduced operating revenues and litigation expenses from defending the tort claims (it has a high-deductible self-insured retention insurance program). Although Debtor A’s total debts far exceed $7.5 million, it is still eligible for Subchapter V because all of the parent debt and contingent tort liabilities are excluded under §1182(A), leaving aggregate qualifying debts of only $7.2 million ($3M Bank Z debt, $3.1M Banks Y and X debt, and $1.1M trade debt). Further, under §1182(B)(i), should Affiliates B and C also file for bankruptcy, Affiliate C’s additional $250,000 in noncontingent, non-insider debts bring the aggregate debts of the group up to only $7.45 million—under the Subchapter V debt limit and all three entities would qualify for Subchapter V. The §§1182(B)(ii)-(iii) exceptions also would not apply because Debtor A’s parent is not a public company, and none of the entities are “issuers” under 15 U.S.C. §78c. While a detailed analysis of what constitutes an “issuer” is beyond the scope of this article, practitioners should note that it remains unsettled whether this subparagraph is limited to affiliates of public companies or applicable to any company that has issued securities.
In sum, before ruling out a Subchapter V bankruptcy filing—and its numerous cost-saving and substantive advantages for debtors—middle market companies should discuss the nature of their liabilities with counsel. If Subchapter V relief is available, it may provide an extremely attractive debt restructuring option, thereby positioning the company to capture post-COVID-19 opportunities that might otherwise be out of reach.
Reprinted with permission from the September 17, 2021 issue of the New York Law Journal. © 2021 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved. For information, contact 877-257-3382 or email@example.com or visit www.almreprints.com.