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Bankruptcy Law Changes: Silver Lining in Dark Cloud

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Are you optimistic about the future of your small business? The National Federation of Independent Business (NFIB) reported in April 2022 that the number of businesses expecting brighter days ahead has dropped to its lowest level in almost half a century. Inflation is the main driving force. 

Thousands of small businesses have closed or reorganized their operations during the pandemic. If your business is struggling, you may find some relief from recent improvements to federal bankruptcy laws, most prominently the Small Business Reorganization Act (SBRA). This important legislation went into effect on February 19, 2020.

However, you may not be aware of the law's provisions—unless you've been seriously contemplating bankruptcy and discussed the changes with your financial and legal advisors. Here's a brief overview.

Bankruptcy 101

For starters, it's important to be familiar with the following three key chapters of the U.S. Bankruptcy Code:

  1. Chapter 7 (liquidation) calls for assets to be auctioned off or sold piecemeal, often leaving creditors with little or nothing.
  2. Chapter 11 (reorganization) allows a business to restructure its debt.
  3. Chapter 13 permits individual debtors to propose a repayment plan to make installments to creditors over three to five years.

What's appropriate depends on the situation. If you're struggling to stay afloat, your legal and financial advisors can help you understand these options.

Close-Up on Reorganization

Although technically available to both businesses and individuals, Chapter 11 (reorganization) is used primarily by businesses. Currently, it applies to debts of less than $2,725,625. Under the CARES Act, the limit was nearly tripled to $7.5 million, but the higher threshold expired on March 27, 2021.

A bankruptcy reorganization usually starts with a voluntary petition to the bankruptcy court filed by the debtor. Conversely, an involuntary petition is filed by creditors after certain conditions have been met. In either event, the business typically has about four months to develop the reorganization plan. However, if just cause for a delay can be shown, the court may grant a business up to 18 months after the filing of the petition to develop its plan. Eventually, the goal is for the business to emerge from the bankruptcy in better financial shape.

Typically, a Chapter 11 bankruptcy proceeding offers protection of business assets while restructuring the following types of debts:

Priority tax debts. Chapter 11 may be used to reorganize past due taxes that your company has incurred. This covers income taxes, payroll taxes and property taxes. Under Chapter 11, your business may continue to operate as you meet your tax responsibilities. Although tax obligations are usually paid off during a five-year period, Chapter 11 allows you to renegotiate the repayment terms with the appropriate taxing authorities and reach a mutually beneficial agreement.

Secured debts. A business identifies secured debts and corresponding collateral contributing to the profitability of the business, similar to the way that secured debts are reorganized for individuals who file for Chapter 11 relief. Accordingly, the business then seeks to pay the current value of the property, as opposed to the amount that's owed. This treatment could apply to collateral, such as real estate, business equipment and vehicles.

For example, suppose your business owns equipment that's worth $250,000, but you still owe the bank $500,000 from the purchase of the equipment. You can ask the court to allow you to pay only the current value of $250,000. This enables your business to reduce its monthly operating expenses.

Unsecured debts. A business may incur significant credit card charges or other unsecured loans in the early years of operation or for ongoing operating costs. Chapter 11 allows a business to restructure this unsecured debt and pay it off in a lump sum or over several years.

In the optimal situation, your business and unsecured creditors will agree on payment terms. If the parties can't come to a reasonable agreement, the bankruptcy judge will decide the outcome in a binding determination.

Leases and contract debts. Assuming Chapter 11 relief is available, a business can choose to accept or reject certain leases and contracts. For instance, suppose your business previously contracted with a janitorial service for a three-year period, then you find a comparable service at a considerably lower price. If you can demonstrate that this contract would contribute to the profitability of the business, the judge may grant a replacement request.

Recent Improvements to the Law

Historically, it was difficult and expensive for small business owners to seek bankruptcy protection under Chapter 11. The SBRA is designed to provide greater access to Chapter 11 for small businesses through a new subchapter devoted exclusively to this class of debtors. But remember the debt limit remains at $2,725,625 now that the CARES Act increase has expired.

Notably, the SBRA provides for the following key changes:

Streamlined reorganizations. It facilitates small business reorganizations by eliminating certain procedural requirements and reducing costs. Significantly, no one except the business debtor can propose a plan of reorganization. Plus, the debtor isn't required to obtain approval or solicit votes for plan confirmation. Absent a court order, there's no unsecured creditor committee. The SBRA also requires the court to hold a status conference within 60 days of the petition filing, giving the debtor 90 days to file its plan.

New value rule. The SBRA repeals the requirement that equity holders of the small business debtor must provide "new value" to retain their equity interest without fully paying off creditors. Instead, the plan must be nondiscriminatory, as well as "fair and equitable." In addition, similar to Chapter 13, the debtor's entire projected disposable income must be applied to payments or the value of property to be distributed can't amount to less than the debtor's projected disposable income.

Trustee appointments. A standing trustee will be appointed to serve as the trustee for the bankruptcy estate. Similar to Chapter 12 bankruptcies for family-owned farms and fishing operations, the revised version of Chapter 11 allows the trustee to preside over the reorganization and monitor its progress.

Administrative expense claims. Previously, a debtor had to pay, on the effective date of the plan, any administrative expense claims, including claims incurred by the debtor for goods and services after a petition has been filed. Under the SBRA, a small business debtor is permitted to stretch payment of administrative expense claims over the term of the plan, giving this class of debtors a distinct advantage.

Residential mortgages. The legislation eliminates the prohibition against a small business debtor modifying his or her residential mortgages. Thus, the debtor will have more leeway if the underlying loan wasn't used to acquire the residence and was used primarily for the debtor's small business. Otherwise, secured lenders continue to have the same protections they have in other Chapter 11 cases.

Discharges. The SBRA provides that the court must grant the debtor a discharge after completing payments within the first three years of the plan or a longer period of up to five years established by the judge. The discharge will relieve the debtor of personal liability for all debts under the plan except for amounts due after the last payment date and certain nondischargeable debts.

Additionally, the exceptions to discharge contained in Section 523(a) of the Bankruptcy Code now apply to the small business debtor. Prior to the law change, a Chapter 11 bankruptcy allowed only limited discharge exceptions.

New Electronic Notice and Service Requirements

Several key changes to the Federal Rules of Bankruptcy Procedure went into effect on December 1, 2021. The most noteworthy revision applies to Bankruptcy Rule 9036 addressing notice and service requirements made through electronic transmission

When notice or service pursuant to a bankruptcy is required, Bankruptcy Rule 9036 allows certain documents to be sent electronically. The amendments to Bankruptcy Rule 9036 are designed to deal with voluminous notices. The clerk is now allowed to send notice or serve registered users by using CM/ECF (the court's electronic filing system). The clerk also may serve any recipient by electronic means if the recipient previously consented to electronic notice in writing, subject to certain exceptions.

Furthermore, amended Rule 9036 clarifies that electronic notice or service is complete upon transmission. The recipient assumes responsibility for keeping its electronic address current with the clerk.

What's Right for Your Business?

In the past, small businesses seeking Chapter 11 bankruptcy relief were often hampered by their size and lack of resources. Under the current law, more opportunities are available for small business reorganizations. Contact your SSB advisor and your financial and legal advisors with questions regarding your bankruptcy rights and the application of the laws to your situation.

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