- Corporate Finance
- Litigation Support
- Strategic Advisory Services
- Turnaround and Restructuring
As published in the Michigan Bankruptcy Journal Fall Newsletter
The impact of COVID-19 on the U.S. economy is well-documented. If you are like me, you have participated in countless “Zoom” calls and webinars coverings a wide array of topics. COVID-19, along with many of the government regulations implemented to control the spread of the virus, forced both public and private enterprises to discontinue operations, or modify the way they reached out to their market. Stay at home orders transformed the way that companies did business; switching from in-store to online, from dine-in to carry-out, and from business lunches to zoom chats – business may never be the same. For the most part, lenders have been accommodating by modifying loan agreements, extending forbearance, and in some cases re-amortizing loan balances over longer periods. Some businesses have thrived, taking advantage of government loan programs while at the same time streamlining their business. Unfortunately, many companies had to shut down permanently. And just because a business has survived the last nine months does not mean they will not face difficult decisions over the next year or so.
Many businesses, particularly small businesses, are coping with lower revenues, as well as fixed costs that have not decreased in proportion to their revenue base. Many businesses are unable to pay their creditors. As such, these struggling businesses will need to reorganize their business and restructure their debt obligations. Since most of my client base is considered middle market, I wanted to cover some of the reorganization options that are available to small business owners. This article will discuss what the Small Business Reorganization Act (the “SBRA”) is and its benefits for small businesses, as well as several alternatives to bankruptcy that could prove to be more affordable and efficient for small businesses.
Small Business Reorganization Act (the “SBRA”)
On February 19, 2020, the Small Business Reorganization Act went into effect, shortly preceding the unprecedented blow to the global economy caused by the coronavirus (COVID-19) pandemic. The SBRA was intended “to streamline the process by which small business debtors reorganize and rehabilitate their financial affairs.”¹ By allowing for a timely, cost effective reorganization, the SBRA would allow small business debtors to remain in business and also benefits others that rely on that business, including employees, customers, and suppliers. The original debt limit under SBRA was set at $2,725,625 but as a result of the Coronavirus Aid, Relief, and Economic Security Act, also known as the CARES Act passed earlier this year, the eligibility requirement was raised to $7,500,000 for cases filed after March 27, 2020, with the increased eligibility remaining in effect for one year. There has been much discussion about raising the debt limit up to $10 million so I am hopeful the limit does not revert to the lower debt limit.
Prior to the SBRA, the primary “in-court” options for struggling small businesses were limited to either Chapter 7 liquidation or Chapter 11 reorganization, both of which have their drawbacks. A Chapter 7 liquidation is certainly less costly, but involves the debtor’s losing control of its operations and the assets being liquidated by a trustee to pay creditors, rendering the business unable to survive. Conversely, a Chapter 11 bankruptcy permits the debtor to retain control of its operations and restructure its debts through a court-approved plan, but the extensive court oversight and stringent requirements associated with this option can be too expensive for small businesses.
The SBRA was intended to be a middle ground somewhere between Chapter 7 and Chapter 11 by allowing the small business debtor to retain control of their business, appointing a trustee to ensure the reorganization proceeds efficiently, and eliminating significant costs and time delays associated with Chapter 11. Specifically, the SBRA:
• Modifies confirmation requirements;
• Provides for the participation of a trustee (the “sub V trustee”) while the debtor remains in possession of assets and operates the business as a debtor-in-possession;
• Changes several administrative and procedural rules;
• Alters the rules for the debtor’s discharge and the definition of property the estate acquires post-petition and with post-petition earnings;
• Absent a court order, a creditors committee is not appointed, which allows the debtor to avoid considerable expenses relating to the committee and the professionals hired by the committee;
• Unlike an ordinary Chapter 11 case, the SBRA does not require the debtor to file a disclosure statement; and
• Only the debtor can submit a reorganization plan, which it must do within 90 days of the commencement of the case.
The SBRA further affords the small business debtor greater latitude for the confirmation of the reorganization plan and permits the debtor to maintain its ownership interest following reorganization, so long as the plan does not discriminate unfairly and is fair and equitable to each class of claims provided for in the plan. Plans will normally be confirmed if they provide that all projected disposable income of the business will be paid to creditors over the following 3 to 5-year period. In summary, the SBRA will be extremely beneficial to small businesses in the current environment by providing small businesses with a quicker, more efficient path for reorganization, by reducing costs and streamlining the bankruptcy process.
Alternatives to Bankruptcy
For small businesses that would like to avoid the overall expense and negative stigma associated with filing bankruptcy, there are other alternatives available to limit the damaging impact of the coronavirus. However, it is important, for businesses to understand the similarities and differences between traditional bankruptcy and its alternatives such, receiverships, assignments for the benefit of creditors, and out-of-court workouts. Below is a brief overview of each:
Receiverships are court-ordered proceedings that are initiated by creditors in which all of a company’s property that is subject to a dispute is placed under the control of an independent third-party, otherwise known as a “Receiver”. Receivers are governed by specific orders and are appointed to preserve distressed assets and attempt to maximize the value of the property. Receiverships provide a means in which secured creditors may quickly and efficiently liquidate a distressed business and are favored by secured creditors of smaller businesses that cannot afford the fees associated with a Chapter 11 bankruptcy. Receiverships provide many of the protections afforded by bankruptcy proceedings, while having the added benefit that: (1) a receivership can be commenced by a lender; (2) the costs associated with a receivership can be less than in a bankruptcy proceeding; (3) a lender has more control over who will be operating the business and the timing of decisions related to the disposition of the lender’s collateral; and (4) recoveries can be enhanced by instituting improvements in the business operations and the pursuit of claims against third parties. Other advantages to receivership include:
• Receiverships tend to be more flexible for creditors;
• Provides an easy, quick method of liquidating assets;
• Avoids investigation of preference claims by the bankruptcy trustee;
• Requires court oversight of the liquidation;
• Stays creditor actions under certain circumstances; and
• The receiver can still pursue fraudulent conveyance actions.
Just like an assignment for the benefit of creditors, (“ABC”), receiverships do have some advantages when compared to traditional bankruptcy proceedings, but they also have significant disadvantages that include:
• It is still a judicial process;
• It does not stop involuntary bankruptcy;
• Assets, if any, are usually sold for nominal value;
• The most obvious disadvantage of receivership is the lack of a conventional discharge of debts; and
• Another disadvantage is the inability of the receiver to recover preferential transfers.
Assignment for the Benefit of Creditors
An ABC is another avenue for the orderly liquidation or wind-down of a distressed business. Much like bankruptcy, an ABC can also be used to facilitate a going-concern sale of the debtor’s assets. An ABC can provide an expedient and smooth transition if the goal is to transfer the assets of the troubled business to a third-party free of any unsecured debt incurred by the transferor. The ABC is also a way to wind down the business with minimal negative publicity, or potential liability for directors and management.
An ABC begins when an assignor, usually the debtor, irrevocably transfers or assigns substantially all of its property to an assignee for the purpose of conducting the orderly wind down and liquidation of the business for the benefit of the assignor’s creditors, which may also include a sale of assets or going concern sale. The powers and duties of the assignee are comparable to those of the bankruptcy trustee, and include collecting and liquidating assets, providing notices to creditors, operating the assignor’s business if necessary, and submitting a final report, among other things. As such, an ABC is similar to bankruptcy in many respects, but there are also significant differences, as well as advantages and disadvantages.
An ABC is cheaper, faster, and more discrete than a traditional Chapter 7 or Chapter 11 filing, which benefits both the debtor and the creditors because there will be more money available for distribution. Unlike the selection of a bankruptcy trustee, the assignor is permitted to choose the assignee to ensure its property is distributed efficiently, and the assignor is more involved in the decision-making process of an ABC. Most of us are familiar with Section 363 of the bankruptcy code which offers of the advantage of selling assets “free and clear”. However, a buyer seeking to purchase a going concern operation, or the specific assets of a distressed business, can obtain substantially similar relief in an ABC sale without the cost and process associated with bankruptcy if certain precautions are taken. These precautions include running the sale process in a commercially reasonable manner, providing adequate notice similar to the public nature of an Article 9 or bankruptcy sale. The more the sale process deviates toward a private sale format, the more risk there is to the buyer from attacks by creditors.
One of the key disadvantages of ABC is there is no automatic stay, and creditors are not prohibited from filing an involuntary bankruptcy petition against the business after it has made an assignment. Credits may also take other actions to stymie the assignee’s administration of assets. Other disadvantages include: the assignee does not have the authority to avoid preferential transfers; the assignee, unlike a debtor or bankruptcy trustee, does not have the power to assume and assign executory contracts and leases without the consent of the counterparty to the contract; and most importantly, ABCs do not provide for the discharge of the assignor’s debts.
Out of Court Workouts
When circumstances allow, the best option for a struggling business is to avoid the expense and hassle of legal proceedings and instead negotiate a workout agreement with creditors. A workout is often an effective tool in preventing creditors from taking legal action against the business in exchange for a partial or complete repayment of the delinquent debt. If an agreement can be reached with all creditors, it will accomplish many of the same goals and objectives of a chapter 11 bankruptcy without the associated expenses and burdens. Using the funds that would otherwise be used to pay the costs and expenses of a Chapter 11 bankruptcy to repay the creditors is often a good incentive for creditors to consider accepting the workout plan.
In a Chapter 11 bankruptcy, a dissenting creditor could be compelled to accept a plan. However, a disadvantage of a workout is that the business has no ability to involuntarily bind any unwilling creditor that may refuse to consent to the workout plan. In addition, the invitation to creditors to meet with management will also give the creditors a forum to meet one another. Depending upon the situation, this introduction may serve as a vehicle for creditors to force the business into an involuntary bankruptcy, or to allow creditors to share unwanted information about the business with one another.
If it appears that there is no way to turn the business around within a reasonable period, then the business may need to be liquidated. If the business is insolvent, this liquidation will normally be achieved by either a Chapter 7 bankruptcy or an ABC.
It is undeniable that the COVID-19 has created significant hurdles for businesses, particularly small businesses. Although some businesses have been able to “weather the storm” and in some cases thrive, more businesses will continue to face financial challenges. As a result, struggling businesses will need to lean heavily on the SBRA to reorganize and maintain operations for the future. In the alternative, these businesses may be able to utilize alternative reorganization options such as ABCs or Receiverships, or they could attempt to negotiate an out of court workout with creditors.
Because no two situations are exactly alike, the foregoing options will have differing impacts on each business. Choosing the right option for your particular situation not only requires the expertise of an experienced bankruptcy attorney, who understand both the law and the effect of each of these options, you will also want to engage an experienced business turnaround financial advisor to assist in the management of the workout process. The turnaround professional can often uncover inefficiencies across a broad spectrum of industries and assist senior managers and leaders in the creation and implementation of successful new business strategies that generate cash flows, preserve value, and repair strained relations with the company’s stakeholders. A turnaround financial advisor can often assist management in preparing the financial projections of the business, communicating with creditors, and formulating, negotiating, and implementing the workout plan. Managing a workout can be a very time-consuming and stressful job and the turnaround financial advisor and business bankruptcy attorney can alleviate some of the burdens and strains of managing a workout plan and communicating with creditors.