Understanding Chapter 7 Bankruptcy: Is a Fresh Start Right for You?

After years of doing general practice work,I now mainly practice in the area of bankruptcy. I represent consumers and businesses in bankruptcy handling cases that are $10,000 to large multi-million dollar cases. Recently, Congress modified Chapter 11 bankruptcy law to accommodate small businesses and it was signed into law. The new law, the Small Business Reorganization Act of 2019 (“SBRA”), codified under 11 U.S.C §§ 1181-1195, is designed to help small businesses prosecute a Chapter 11 bankruptcy without all of the form requirements of a full Chapter 11. In light of our current pandemic with COVID-19 it couldn't have happened at a better time. The SBRA’s benefit is to streamline the process of reorganization which in turn reduces the overall costs for a small business to access bankruptcy. That in turn helps owners, employees, suppliers, customers and others who rely on the business utilizing the SBRA. So, even though SBRA falls under the Chapter 11 code, it resembles a Chapter 12 (farmers) or Chapter 13 (consumer) bankruptcies. It provides for a trustee in the case while leaving the debtor in possession of assets and control of the business. The trustee oversees and monitors the case and may be involved in some estate related matters such as objection hearings or disbursals to creditors. As opposed to Chapters 7, 12 and 13, Congress decided that there would be two sets of statutory rules for small business bankruptcies under Chapter 11. The debtor when deciding to file must choose a Chapter 11 case, or for the small business cases, they are referred to as a case under Subchapter V of Chapter 11. But practitioners are likely to refer the small business cases under SBRA as a “Subchapter V Case” or a “Sub V”. Before SBRA was enacted, small business had limited options. A small business corporation can file into a Chapter 7 bankruptcy, but could not further exist after the bankruptcy was completed because such a corporation could not obtain a discharge. Small business corporations are prohibited from filing a Chapter 13 to reorganize, so the only remedy for a small business corporation was to file into a Chapter 11. Chapter 11 bankruptcy have onerous rules and can be expensive, sometimes running into tens of thousands of dollars. The reason the SBRA is important is because is fills a vacancy for the type of debtor that is too small to file into a Chapter 11 and too big to file into a standard Chapter 13. For example, a sole proprietorship business can file into a chapter 13, but would be subject to debt caps for secured (less than $1,184,200) and unsecured (less than $394,725). Such a debtor would also be forced to file into a Chapter 11, causing the debtor to incur large attorney costs and expenses on the case. Subchapter V fills that need. Before the SBRA was enacted, a small business under § 101(51D) of the code, a small business debtor was defined as 1) engaged in commercial or business activities; 2) excluded small businesses that own real property; 3) aggregate debts of $2,725,625 (note that the cap is temporary increased to $7,500,000 pursuant to the CARES Act); 4) if the US Bankruptcy Trustee has not appointed a committee of unsecured creditors or the Court determines that such committee is not active enough to provide effective oversite. Under the SBRA, those rules have changed. As to commercial activity, the SBRA still required the Debtor to engage in commercial or business activities, but make the following new and different requirements: 1) Revised paragraph (A) of § 101(51D) requires that more that 50 percent of the Debt of the Debtor arise from commercial or business activities of the debtor. 2) The amended § 101(51D)(A) excludes a debtor from engaging in, owning or operating real property from being a small business debtor only if the debtor owns or operates single asset real estate. 3) It is required that no creditors committee exist (which was required under the old rule) is eliminated). So, under the new rule the SBRA provides that no committee will be appointed in the case of a small business debtor, unless otherwise ordered by the court. 4) The debtor cannot be required to report to the SEC under § 13 or 15(d) of the Securities and Exchange Act of 1934 as an entity or affiliate of such and entity. So, to be clear, pursuant to the amendments to the Code, the SBRA amended the definition of a “small business case” to exclude a Subchapter V debtor. Oddly, that means that a small business debtor, when electing to file under Subchapter V, is not defined as a “small business case”, but is defined as a Subchapter V case because of the new requirements. Procedurally, the case moves along in similar way to a Chapter 12 or 13 case. The petition and schedules are filed, a plan is proposed and a motions are filed to confirm the plan. A Trustee is appointed early on in the case to oversee the case. But acts as an passive trustee, under the Subchapter V debtor elects to liquidate assets and seek a discharge (similar to Chapter 7). The trustee’s role is oversight but must appear at any hearing regarding values of assets of the estate, confirmation of the plan, modification of the plan, and/or sale of bankruptcy estate property. In addition, the trustee has a broad duty to investigate estate assets and claims under § 1106(a)(3), unless the ordered by the court. As with a standard Chapter 11 case, the debtor remains in possession of the assets of the estate, unless otherwise ordered by the Court. Cramdown rules for Chapter 11 also have changed under Subchapter V. § 1129(b) of the bankruptcy code permits a cramdown of impaired classes (creditors that have to take a haircut on the debt) if at least one impaired class accepts the plan. So, you cannot confirm a plan where no impaired class has accepted the plan. Of greater importance is “the absolute priority rule” under § 1129(b)(2)(B) which prohibits holders of stock in the entity filing from retaining their interests unless unsecured creditors receive full payment. In an individual Chapter 11 case, the effect of that is debtors cannot retain property without full payment to unsecured creditors. This rule is the main reason why so many small business Chapter 11 bankruptcies fail or are never filed at all. Subchapter V rules change the playing field to the benefit of Subchapter V debtors. First, § 1129(b) (absolute priority rule) does not apply in a Subchapter V case. Now § 1191(b) revises the cramdown rules that permit a cramdown of all impaired classes, even if the impaired class refuses to accept the plan. And, under § 1191(b), if all other confirmation requirements are met, the Court must confirm the plan even if there are impaired classes that have not approved it if the plan 1) does not discriminate unfairly and 2) is fair and equitable. Interestingly, these are the two rules that govern cramdowns under a standard Chapter 11 case, but with the absolute priority rule eliminated, Subchapter V cases should be confirmed more frequently with less cost. Last, ordinarily, a corporation cannot obtain a discharge in a Chapter 7 liquidation case, but can in a standard Chapter 11 case, which, of course is subject to all of the costs and rules described above. Under Subchapter V, however, when the Court confirms the cramdown plan the debtor, upon completion of the plan can obtain a discharge under § 1192. Specifically, under § 1192 the debtor is allowed a discharge to occur “as soon as practicable” after all plan payments are made under a three year or up to five year plan (as opposed to a standard Chapter 11, no plan under Subchapter V may exceed five years). The discharge is subject to the standard non-dischargeable debts such as administrative expenses, trustee expenses, support obligations, student loans, some taxes and other such claims. Now a small corporate business and individual debtor can obtain a discharge under Subchapter V in the same way as a bankruptcy discharge is available to a Chapter 7 or 13 debtor. This is especially enticing for the small business debtor who has a secured debts, such as real property or equipment, but also has a large amount of unsecured debt. Such a debtor will keep the secured assets, as long as they follow the plan payments, and discharge the unsecured debts upon completion of the plan, just like a Chapter 13. While the new law has its own nuances, it provides a way for a small business or individual debtor with a sole proprietorship that do not fit into a standard Chapter 11 to obtain bankruptcy relief such that the debtor can enter into a bankruptcy, obtain an automatic stay to stop creditors from collecting, and subsequently obtain a discharge of debts in a stream lined and low cost manner.