The New Small Business Reorganization Act: A Look at Courts’ Interpretation of New Issues in the Act’s First Few Months, Part II

As the world has reeled from the impact of COVID-19 this spring, bankruptcy courts across the country  have also been adjusting to a new type of bankruptcy case – the first bankruptcy cases filed under the new subchapter 5 of the Bankruptcy Code (“subchapter 5”). This new bankruptcy process provides for a streamlined, hopefully more cost-effective process for small businesses to file for bankruptcy and reorganize. The Small Business Reorganization Act (the “SBRA”) outlines the subchapter 5 process, and The Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) temporarily increased the debt limit for small businesses to be eligible to file for bankruptcy pursuant to subchapter 5 from $2,725,625 to $7,500,000; this increased limit stays in effect until late March 2021. While ambiguities in the SBRA and the new process will be worked out through case law over the next few months and years, the limited SBRA precedent that has already been established by courts in the last four months may be helpful for small businesses currently evaluating their finances and options in the coming months – especially as the future is uncertain due to COVID-19. Courts have primarily focused on three primary questions; part two of this two-part blog series will address the definition of a “small business debtor,” and the role and powers of a subchapter 5 trustee. To view part one which examined a debtor’s election to proceed as a subchapter 5 debtor, click here.

Does a debtor under the SBRA need to be currently operating? What are “commercial and business activities” that qualify a debtor to proceed under the SBRA?

Courts across the country have also begun to interpret the new definition of a “small business debtor” under the SBRA. A small business debtor is defined in the Bankruptcy Code as a “person engaged in commercial or business activities” that has aggregate debts in amount not to exceed $7,500,000, and “not less than 50 percent of which arose from the commercial or business activities of the debtor.” 11 U.S.C. § 101(51(D)) (as temporarily amended by the CARES Act). As a bankruptcy court in South Carolina recently found, however, there is nothing in this definition or the legislative history of the SBRA that requires a small business debtor to be currently engaged in business or commercial activities.  In re Charles Christopher Wright, Case No. 20-01035 (Bankr. D.S.C. April 27, 2020). The court allowed the subchapter 5 bankruptcy petition of a business that had ceased operations in 2018 to continue, finding that the debtor was “engaged in commercial or business activities” by addressing its residual business debt through the bankruptcy case. Bankruptcy pursuant to subchapter 5 may therefore be a viable option for sole proprietors and business partners who are unsure how to address debts remaining from a recently closed business.

Courts have also grappled with the definition of what “commercial or business activities” apply for a debtor to be eligible to file bankruptcy under the SBRA; this phrase is not defined in the Bankruptcy Code. In a case out of the Eastern District of New York, the bankruptcy court considered whether a debtor who ran a bed and breakfast out of her mortgaged home was eligible to proceed under subchapter 5. The court noted that analyzing “the substance of the transaction and the borrower’s purpose in obtaining the loan,” instead of “merely looking at the form of the transaction” was particularly important.  In re Ventura, Case No. 8-18-77193, 2020 WL 1867898, *12 (Bankr. E.D.N.Y. 2020), citing In re Martin, No. 12-38024, 2013 WL 5423954, *6 (S.D. Tex. 2013). In this case, more than 50% of the debtor’s debt arose from a mortgage that she took out to purchase a residential home where she lived and operated her bed and breakfast. The court found that the debtor’s primary purpose of purchasing the property and obtaining the mortgage was to run the bed and breakfast, and the debtor was eligible to proceed as a small business debtor under the SBRA. As long as 50% or more of a company’s debts were incurred with the purpose of being used in the business, many small businesses and sole proprietors with both consumer and business related debts should consider reorganization under the SBRA as a meaningful option.

Can the role of the subchapter 5 trustee be expanded? Can the trustee hire counsel?

The court-appointed, standing trustee is a new position unique to bankruptcy cases under subchapter 5. The subchapter 5 trustee is appointed to monitor the bankruptcy case, actively participate in certain matters, and ensure that plan payments are made, among other duties, but the subchapter 5 trustee does not have an unfettered ability to investigate the financial affairs of the debtor (like an examiner or chapter 11 trustee otherwise would). 11 U.S.C. § 1183(b). The SBRA allows for the expansion of these duties if the court orders, however, and the bankruptcy court for the Middle District of Northern Carolina found that there was good cause for a limited expansion of the subchapter 5 trustee’s powers to analyze certain intercompany claims. In re AJEM Hospitality, LLC d/b/a AJ’s Burger Shack, et al., Case No. 20-800003, 2020 WL 3125276, *2 (Bankr. M.D.N.C. Mar. 23, 2020).  This expansion of the trustee’s powers was not significant, however; the subchapter 5 trustee was directed specifically to conduct a limited investigation to “review and analyze intercompany claims and to file a statement summarizing this review with the Court, pursuant to § 1106(a)(4).” Id. If parties in other cases seek an expansion of the subchapter 5 trustee’s powers, a request is likely to be successful only if it is discrete and aligns with one of a chapter 11 trustee’s duties in section 1106 of the Bankruptcy Code. Absent a reasonable basis to suspect fraud or mismanagement, a request for a sweeping investigation of the debtor or a broad expansion of the subchapter 5 trustee’s powers will likely be denied.

As new subchapter 5 trustees become involved in cases, debtors and trustees may also wonder if they can or should file an application to employ counsel (as trustees often do as a matter of course in some chapter 7 and chapter 11 bankruptcy cases). A bankruptcy court in the Eastern District of North Carolina has discouraged this practice in subchapter 5, however; the court denied a subchapter 5 trustee’s motion to employ counsel when the trustee “does not need legal assistance to fulfill his basic duties to monitor and facilitate the Debtor’s reorganization.” In re Penland Heating and Air Conditioning, Inc., Case No. 20-01795, 2020 WL 3124585, *2 (Bankr. E.D.N.C. June 11, 2020). Where a trustee demonstrates a need for counsel and needs to be actively involved in litigating an issue, however, trustees are not prohibited from hiring counsel. Unlike chapter 11 bankruptcy cases, the routine hiring of counsel (including oneself, if the trustee is a lawyer), “is contrary to the intent and purpose of the SBRA;” the SBRA was intended to help small businesses use the bankruptcy process to reorganize in a more efficient and less expensive way than chapter 11. Id. The court did note, however, that where counsel for a trustee is necessary and appropriate, “allowing trustees to employ themselves or their firms provides an economical efficiency to case administration.” Id. Given this analysis, subchapter 5 trustees may wish to carefully evaluate the circumstances before filing an application to employ counsel as a matter of course.

As cases filed pursuant to the SBRA progress, there will certainly be more precedent established on plan confirmation issues, the impact of the elimination of the absolute priority rule, and discharge issues; courts’ interpretation of many of these issues remains unknown. Given the compressed timeline of SBRA cases, the temporarily increased debt limit, and the potential for owners to maintain equity while reorganizing their business, a reorganization under the SBRA represents a substantial opportunity for small businesses looking toward an uncertain future.