New Small Business Provisions in Bankruptcy Code

Small businesses considering bankruptcy protection should be aware of recent changes to the Bankruptcy Code – enacted as the pandemic hit the United States and enhanced under the CARES Act. In February 2020, Congress enacted the Small Business Reorganization Act as Subchapter 5 of Chapter 11 of the Bankruptcy Code. It modifies the traditional bankruptcy process set out in Chapter 11 and reduces the cost and expense for small businesses to reorganize. Originally, the debt limit for a small business to qualify under Subchapter 5 was $2.7 million.

The CARES Act, enacted March 27, 2020, increased the debt limit for eligible businesses under the Small Business Reorganization Act from $2.7 million to $7.5 million, to allow more small businesses to take advantage of Subchapter 5. The increase in the debt limit is effective for one year after enactment of the CARES Act – until March 27, 2021. Certain companies that previously filed under regular Chapter 11 have successfully been able to convert to cases under Subchapter 5.

Subchapter 5 (with the increased debt limit under the CARES Act) may provide many small businesses with a more attractive option for bankruptcy protection. Among other advantages, the provisions provide for a more streamlined confirmation process (generally without a disclosure statement), no requirement for creditors’ committees, and the ability to confirm a plan without needing to obtain approval by a class of impaired creditors or complying with the absolute priority rule, so long as the plan provides for the application of all projected “disposable income” over three to five years to payments under the plan. Thus, the Subchapter 5 process may offer a less costly form of bankruptcy relief, with the ability to retain equity, so long as the debtor dedicates all of their disposable income for three to five years to the payment of creditors. Subchapter 5 also provides for the involvement of a trustee in all cases, including to facilitate the development of a consensual plan of reorganization, but the trustee’s role is generally more limited than in typical trustee cases.

Issues for Paycheck Protection Program Borrowers

Many small businesses – nearly 5 million nationwide – received loans under the popular Paycheck Protection Program (“PPP”), also part of the CARES Act. If they are considering bankruptcy, PPP borrowers may have questions about the interaction of the PPP program and bankruptcy proceedings.

• Unsecured Loan. Since PPP loans are unsecured, with no collateral required (and no personal guarantee), if a PPP borrower goes into bankruptcy, the government would have a general unsecured claim against the borrower in bankruptcy.

• Use of PPP Loan Funds. PPP borrowers may be concerned about the use of loan funds in a bankruptcy proceeding, since the CARES Act limits the permissible use of funds. Whether a bankruptcy court could require PPP loan funds to be spent on costs not permitted under the CARES Act is an open, untested question.

• Fraud Concerns. Businesses that had filed for bankruptcy before applying for PPP loans are not eligible under SBA rules to receive PPP loans. Although some Bankruptcy Courts have enjoined the SBA from applying this rule under the anti-discrimination provisions of the Bankruptcy Code, a number of more recent cases have generally upheld the SBA rule. Businesses that apply for PPP loans and then file for bankruptcy before being approved are required to inform their lenders and withdraw their applications for PPP loans. However, a business is not prohibited from filing for bankruptcy after receiving a PPP loan. To avoid concerns about fraud in such a situation, it is important that no facts suggest that the bankruptcy filing was postponed to allow the borrower to receive a PPP loan.

The issues facing small businesses today are unprecedented and complex. Traditional challenges interact with new programs, creating novel issues. It is important to consult counsel for assistance when navigating these challenges. Vinson & Elkins is monitoring the developments facing businesses during the pandemic and offers clients our cross-disciplinary approach to best resolve issues they face today.