Important Changes for Small Business Debtors Under BAPCPA - ABA YLD 101 Practice Series

By Michael Thieme

Chapter 11 - reorganization through bankruptcy - may be an advantage for firms that possess basic business viability. Specifically, Chapter 11 can allow a small business to obtain post-petition financing by priming existing creditors, and to generate cash revenue in excess of the money that is disbursed. However, many small businesses end up in Chapter 11 to retain control of operations after they have hit hard times. Sometimes, they are merely postponing the inevitable - liquidation and closing of their doors. In my experience, the typical reasons that small business file for chapter 11 protection are: the need to keep the landlord from evicting them from the premises; dealing with a troublesome lawsuit (which is automatically stayed once the bankruptcy is filed); or the eventual realization that something in their business model is not working. Many small business debtors file Chapter 11 to get creditors off their backs for a period, with the hope that they can iron out the kinks in their business plans, and generate excess cash by selling off some underperforming assets or rejecting a few below-market leases. The statistics, however, do not paint a picture of success.

More than 80% of Chapter 11 business debtors do not successfully emerge from Chapter 11 - they either do not emerge at all, or they end up becoming repeat customers within a short period of time (the so-called "Chapter 22"). The failure rate for small businesses is even more grim. The National Bankruptcy Review Commission (the "Commission"), in its report nine years ago, realized that not all was well with Chapter 11. See the Commission's "Bankruptcy: The Next Twenty Years" report dated October 20, 1997. The changes that the Bankruptcy Reform Act of 2005 ("BAPCPA") brought for small business debtors were no surprise to anyone familiar with the Commission's report. As a matter of fact, Congress adopted nearly verbatim many of the changes suggested by the Commission. For example, amended section 1112, which contains new provisions dealing with dismissal, is taken in large part word-for-word from the report. While the "harshest" amendments brought on by BAPCPA were aimed at individuals in Chapter 7 and their professionals, small business debtors were by no means spared by the changes set forth in BAPCPA.

The Commission clearly was not impressed with small business debtors' prospects for success in Chapter 11. In a nutshell, the Commission reported that the vast majority of small business debtors who end up in Chapter 11 do so to stave off an inevitable liquidation. It also stated that the small minority of small business Chapter 11 debtors who have some chance of success should reorganize, quickly, file a plan, and get out of Chapter 11. Because Chapter 11, as a whole, is geared toward larger businesses which require longer deadlines to reorganize, too often small business debtors take advantage of these procedures and simply "hang out" in Chapter 11 to the detriment of creditors. To change this picture, the Commission proposed tight deadlines and "death penalty" clauses - committing a small misstep would lead to case conversion or dismissal. This approach, the Commission thought, would serve two purposes for small business debtors: quickly separate the wheat from the chaff, and keep everyone marching forward at a brisk pace through Chapter 11.

Under the Bankruptcy Code as modified by BAPCPA, a "small business debtor" is a person with debts below $2 million dollars who is not in the business of owning or operating real estate. 11 U.S.C. § 101(51D). A "person" can be an individual or a business entity. See 11 U.S.C. §101(41). The $2 million limit excludes any debt owed to insiders or affiliates. The definition of "small business debtor" has been amended to include any affiliate that is also a debtor, except for any member of an affiliated group of debtors with debt exceeding the $2 million limit (exclusive of debt owed to insiders or affiliates).

Under the definitions, a limited liability company and an individual who operates as a "d/b/a" could both qualify as small business debtors.If that small business debtor ("SBD") files a Chapter 11, the court then has a "small business case," and the debtor has to comply with a whole host of additional requirements. 11 U.S.C. § 101(51C). To confuse matters somewhat, an SBD ceases being such if the U.S. Trustee manages to organize and appoint a creditors' committee. However, it does not stop there; such a debtor would apparently revert to being an SBD once again if the court determined that the creditors' committee is not sufficiently active in the case. See 11 U.S.C. § 101(51D). What remains unanswered is the question of what happens to the debtor's "small business" status if the creditors' committee, having just been told by the court that it is not doing its job, is motivated into becoming "sufficiently active."

Being an SBD also brings with it a whole host of requirements to fulfill, deadlines to meet and pitfalls to avoid. Individual Chapter 11 SBDs must obtain credit counseling within 180 days of filing for bankruptcy, file copies of tax returns, if requested to do so, and complete a financial management course prior to discharge. SBDs will not receive the protection of the automatic stay in a voluntary case if another case was dismissed in the two years before the order for relief, if a plan was confirmed in another case in that timeframe, or if the debtor acquired the assets of another small business debtor. See 11 U.S.C. § 362(n)(2). An SBD's deadline to file schedules cannot be extended by the court beyond 30 days absent "extraordinary and compelling circumstances." The SBD has to file tax returns and financial filings within 7 days, meet with the U.S. Trustee prior to the § 341 creditors' meeting, and timely file profitability and progress reports. See 11 U.S.C. § 1116. In addition, the SBD, in its subsequent reports, must contain comparisons of earlier projected cash receipts and disbursements with actual results. Such comparisons could give creditors ammunition for objecting to the confirmation of the plan on grounds of feasibility.

The time period for filing a plan is likewise shorter if one is an SBD. Post-BAPCPA Chapter 11 debtors typically have up to 18 months to propose a plan, and up to 20 months to have that plan accepted. However, an SBD has exclusivity for 180 days - this is the time period during which only the SBD can propose a plan, and the creditors cannot propose competing plans. Even if not the debtor's, any plan must be filed no later than 300 days after commencement of the small business case. Although BAPCPA actually lengthened these deadlines for SBDs (prior to BAPCPA, after the 1994 amendments to the Code, an SBD had 100 days to file a plan, and any party had 160 days to file a plan and disclosure statement), the new law did not make it easy to get an extension. An SBD must now demonstrate, among other things, that a plan is likely to be confirmed "within a reasonable time" to get the extension. See 11 U.S.C. §1121(e)(3).

One break that SBDs do get under BAPCPA is that a court can dispense with the disclosure statement, or combine final disclosure statement approval with confirmation. See 11 U.S.C. §1125(f). Because, under §1129(e), an SBD's plan typically must be confirmed 45 days after it is filed, a party may make the argument that the short timeframe acts to waive the disclosure statement requirement. Under Bankruptcy Rule 2002(b), 45 days from filing to confirmation is arguably insufficient, since a 25-day notice is required for filing objections to the disclosure statement, plus an additional 25 days for filing objections to the confirmation.

In what may be another BAPCPA drafting glitch, only the SBD may ask to have the confirmation deadline extended, even if the plan was filed by a creditor. See §1121(e)(3)(A). Also, because the 300-day deadline to file is only extendable upon the debtor's request, if the SBD were to retain exclusivity for the entire 300 days upon court approval, the SBD could effectively preclude creditors from filing any plans, since the code has been amended to read that only the debtor may move for an extension of the 300-day deadline.

BAPCPA has laid other traps for the unwary SBD. Newly amended section 1112 lists a variety of reasons for dismissal of a case. Although this section was included in the subchapter of BAPCPA dealing with SBDs and was taken from the Commission's recommendations for small business cases, by its terms it applies to all Chapter 11 debtors. In a nutshell, section 1112 has been amended to require that Chapter 11 cases be dismissed or converted if "cause" is established - previously the judge had discretion to do so, but was not required to dismiss or convert. The definition of "cause" has been expanded to include, inter alia, gross mismanagement of the estate, failure to maintain insurance, failure to comply with court orders, unexcused failure to timely satisfy a reporting or filing requirement, failure to attend a Rule 2004 examination or a §341 meeting of creditors, not providing information to the U.S. Trustee, failure to timely pay or file post-petition taxes and tax returns, and not timely filing a plan or disclosure statement.

So the road to reorganization for an SBD is paved with pitfalls along every step. The greatest hope for avoiding the "death penalty" (i.e., dismissal or conversion) is that the court finds specific "unusual circumstances" that would warrant making an exception. An SBD who forgets to file a post-petition tax return, even if the IRS does not care or complain, would find its case subject to dismissal or conversion if a hostile creditor raised the issue. A sympathetic judge may find "unusual circumstances" warranting an exception, but debtors should not count on such judicial relief. To get this relief, a debtor would have to not only justify the omission, but also additionally prove that the plan is likely to be confirmed within a reasonable period of time. At the early stages of the game, this may be a difficult showing for many SBDs to make. The common law "excusable neglect" doctrine that debtors can sometimes rely on in similar situations would probably be inapplicable under section 1112 because section 1112 explicitly lays out a different standard. The only other way to avoid the "death penalty" of dismissal is to have the court appoint a trustee or an examiner instead of dismissing or converting the case. See 11 U.S.C. §1104(a)(3). An SBD whose Chapter 11 case is dismissed can re-file, but will no longer enjoy the protections of the automatic stay.

The lesson here is that the days when an SBD could fumble through Chapter 11 toward confirming a plan of reorganization are definitely over. There are simply too many traps for the unwary under BAPCPA, so that even a small business debtor needs a qualified bankruptcy professional to help guide it through the process.

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About the Author

Michael Thieme is an associate with Schian Walker in Phoenix, AZ. Mr. Thieme's practice areas include Corporate Restructurings and Reorganization and Commercial Transactions.

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