As a part of our continuing coverage of the 2012-2014 Final Report and Recommendations of the American Bankruptcy Institute’s Commission to Study the Reform of Chapter 11, we’ve reported on a number of the Commission’s proposed revisions and reforms to the Bankruptcy Code, many of which (i.e., systemically important financial institutions, cross-border cases, DIP financing, etc.) primarily impact the traditional big players in large-scale or so-called “mega” chapter 11 cases that dominate the media headlines: companies with complex corporate structures and hundreds of millions of dollars on their balance sheets. The “one percenters” of chapter 11, if you will. But what about the little guy? What about the family owned businesses, the mom and pop stores, and the startup companies that form the “backbone” of the American economy?

As noted in the Report, most business bankruptcies filed in the United States involve small and middle-market enterprises and, according to the U.S. Economic Census, companies with 50 to 5,000 employees account for more employment than those with over 5,000. Nevertheless, many practitioners believe for small and middle market companies, which are prone to preliminary setbacks and can be among the hardest hit in economic downturns, chapter 11 is now viewed as too slow and too costly to accomplish anything other than a liquidation or a going concern sale under section 363. Less experienced or financially sophisticated management teams, relatively smaller pools of assets and liabilities, and vested equity owners who may have either founded or managed the enterprise all present unique challenges to small and mid-sized debtors looking to utilize chapter 11. Thankfully, the Commission has sought to address some of the dysfunctions that have evolved in the Bankruptcy Code in hopes of making chapter 11, once again, a practical and workable solution for rehabilitating small and mid-sized enterprises.

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Background

Congress has previously attempted to address small business debtors, first in 1994 with the introduction of the small business election provisions to chapter 11, and again in 2005 with the BAPCPA amendments. Under these provisions, a debtor that met the definition of a “small business” (with certain exceptions, debtors with noncontingent liquidated secured and unsecured debts that do not exceed $2,190,000) was subject to certain mandatory provisions that were meant to fast track the small business debtor’s chapter 11 case. The amendments, among other things, established presumptive plan filing and confirmation deadlines, additional postpetition documentation requirements, and changes to the burden of proof for small business debtors. For example, pursuant to section 1121(e) of the Bankruptcy Code, a debtor in a small business case has the exclusive right to file a plan for the first 180 days of a chapter 11 case and is required to file a plan and disclosure statement (if any) within the first 300 days of the case unless the debtor has demonstrated by a preponderance of the evidence that it is more likely than not that the court will confirm a plan within a reasonable period of time.

In the Report, however, the Commission notes that several witnesses have suggested that certain of the deadlines imposed by the BAPCPA amendments are particularly challenging and counterproductive for small business debtors. The Report further notes that several witnesses and commentators observed an increasing use of state and federal law insolvency alternatives (i.e., state receiverships and assignments for the benefit of creditors) by small and middle-market enterprises, which the Commission viewed as subpar remedies that present an array of issues for debtors. In response to these issues, the Commission sought to reform chapter 11 for small and medium sized debtors in a manner that would (i) simplify the process, (ii) reduce costs and barriers, and (iii) provide tools to facilitate effective reorganizations for viable companies. With these objectives in mind, the Commission recommended the following reforms in Section VII of their Report with respect to small and medium-sized debtors.

Discussion

Definition of SMEs

The Commission first recommends deleting the “small business case” and “small business debtor” provisions from the Bankruptcy Code in their entirety. In their place, the Commission proposes adding the defined term “small or medium-sized enterprise” or “SME.” According to the Report, an SME would be defined as a business debtor with (i) no publicly traded securities in its capital structure or in the capital structure of any jointly administered debtors, and (ii) less than $10 million in consolidated assets or liabilities. The definition of SME would not include a single asset real estate case.

Any debtor that falls within this definition would receive automatic SME treatment while a debtor with more than $10 million in assets but less than $50 million may apply for recognition to be treated as an SME in its chapter 11 case. According to the Report, the Committee observed a natural breaking point at the $10 million threshold in the data it examined and, when adjusted to exclude chapter 11 filings for individuals and small public companies, the proposed SME standard would capture around 85 to 90 percent of chapter11 filings (see chart above).

Oversight

In most cases, the Bankruptcy Code establishes the U.S. Trustee and the committee of unsecured creditors as the “statutory watchdogs” in the case. Nevertheless, in many SME cases, the U.S. Trustee may not be able to appoint a creditors’ committee because creditors in such cases may not have claims large enough to warrant the time and money to actively participate in the case. In response, the Commission recommends that a creditors’ committee under section 1102(a) should not be appointed in an SME case unless requested by an unsecured creditor or the U.S. Trustee. Recognizing, however, that certain SME debtors may still require oversight to avoid drifting listlessly in chapter 11, the Committee recommends that the bankruptcy court sua sponte, the U.S. Trustee, the debtor in possession, or a party in interest should be able to request the appointment of an estate neutral that has the authority both to investigate and to advise the SME debtor in possession on operational and financial matters. Furthermore, the Committee recommends that an estate neutral, with court authority, could also assist an SME debtor in developing and negotiating its chapter 11 plan, which could provide a valuable resource to those SME debtors that may have inexperienced or less financially sophisticated management teams.

Plan Timeline

The Bankruptcy Code, as amended in 2005, requires that a small business debtor’s chapter 11 plan be confirmed within 45 days of its filing. The Commission, however, notes that several witnesses testified that this was nearly impossible for small business debtors to achieve and further notes that the Code’s other plan confirmation and solicitation deadlines (discussed above) create similar interpretive and practical problems for small business debtors. In working to strike a balance between the need to assess the viability of an SME debtor case early while still allowing viable SME cases a reasonable opportunity to succeed, the Commission recommends a mandatory requirement that the SME debtor file a timeline for filing and soliciting acceptances of its plan within 60 days of the petition date. According to the Report, the Commission set this deadline

to allow time for the SME debtor to settle into the chapter 11 case, resolve any issues relating to its SME designation, and consult with any committee or estate neutral appointed in the case, but still allow the court time to develop deadline for the filing and solicitation of a chapter 11 plan consistent with other provisions of the Bankruptcy Code, such as the debtor’s exclusivity provisions under section 1121.

Plan Content and Confirmation

Perhaps the most sweeping proposal with respect to SMEs, to address the fact that many SMEs are family-owned businesses or businesses in which the founders are still actively involved, the Commission recommends creating an equity retention structure (“SME Equity Retention Plan”) that would appropriately align the interests of prepetition management and equity with the debtor’s reorganization and protect the interests of unsecured creditors, despite noncompliance with the traditional absolute priority rule. To accomplish this, the Commission recommends revising the Code to allow the prepetition equity owners of an SME debtor to retain or receive 100 percent of the voting interests in the reorganized debtor, subject to certain limited voting rights that would be afforded to unsecured creditors. Existing equity, however, would be entitled to receive no more than 15 percent of the reorganized debtor’s economic interests. Under the SME Equity Retention Plan, general unsecured creditors would be granted preferred ownership interests that include limited voting rights on extraordinary transactions (i.e., voting rights with respect to changes in insider compensation, dividends, substantial asset sales, and amendments to organizational documents) and at least 85 percent of the economic ownership interests in the reorganized debtor.

The Commission recommends that the creditors’ preferred interests would mature after four years, at which time such interests would convert into 85 percent of the common stock of the reorganized debtor, unless redeemed in cash on or before the maturity date. In order to provide cash dividends to unsecured creditors prior to maturity of the preferred interests, the Commission recommends that a provision be added in the chapter 11 plan that directs the reorganized SME debtor to pay its excess cash flows to holders of unsecured claims on at least an annual basis. In addition, to satisfy the requirements of an SME Equity Retention Plan, prepetition equity must commit to support the chapter 11 plan, the debtor’s emergence from chapter 11, and its post-confirmation operations.

According to the Report, the Commission believes that under this structure, “both prepetition equity security holders and unsecured creditors have incentives to foster a sustainable and profitable reorganized business.”

Conclusion

Recognizing that “one-size fits all” is rarely the best approach, the Commission has recommended sweeping reforms to the Bankruptcy Code meant to address the fact that chapter 11 has become too costly and too slow to provide small and medium sized enterprises any meaningful chance of successfully reorganizing. These changes, which include changes to small business plan timelines, case oversight, and fundamental chapter 11 plan structures, were meant to address the unique challenges that face small and mid-sized debtors. And perhaps now, finally, someone is looking after the little guy.