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Bankruptcy Update – Protecting Secured Claims In The New Year

With chapter 11 bankruptcy filings on the rise, all businesses are expected to begin feeling the impacts this year. This article provides a summary of significant changes to the bankruptcy code that lenders should be aware of as they navigate anticipated increased bankruptcy filings from borrowers.

Small Business Reorganization Act

The newest form of relief is the Small Business Reorganization Act, which became effective in February of 2020 (the “SBRA”).  The SBRA, as promised, has been effective at allowing business debtors, whether operating through an entity or as individuals, to reorganize in a fast and cost-effective manner.  In addition, and as a result of the CARES Act, eligibility for a debtor to file under the SBRA has been expanded from those debtors who have debt of $2,725,625 to those with debt of $7,500,000 [1].

As background, the SBRA makes changes to the existing chapter 11 process, which will significantly affect many secured creditors.  The significant changes include, for example, the elimination of the “absolute priority rule,” which historically has provided creditors with significant leverage to either force the debtor to propose a plan which pays unsecured (deficiency) claims in full, or otherwise find new money to do so.   Business debtors operating as sole proprietors, may also now under certain conditions modify certain residential mortgages.  Further, the SBRA is designed to move in an accelerated fashion and requires a debtor to have a plan on file within 90 days of filing.  Creditors, including secured creditors, may find themselves impaired without remedy if they do not pay close attention to the debtor’s filings, stated intentions, and court deadlines.

If you receive a notice from a bankruptcy court that your borrower has filed a case under the SBRA, you should immediately keep the following in mind:

  • Consent to Use Cash Collateral – As with the existing chapter 11 debtors, a debtor who files under the SBRA will still need consent to use a lender’s collateral. Therefore, if the lender was not consulted in advance of the bankruptcy filing, it will need to immediately review the debtor’s motion to use cash collateral to ensure the terms of debtors’ use are acceptable to the lender.
  • Accelerated Claims Deadline – To accommodate the accelerated case schedule of the SBRA, Courts generally require that a creditor files a proof of claim as early as within 60 days of the debtor’s filing date. It is imperative, therefore, for creditors to closely monitor the claims bar date to ensure they do not lose their right to assert a claim.
  • Modified Confirmation Process – Under the SBRA, the debtors’ ability to confirm is modified in several material respects, all of which require creditors’ careful oversight to ensure that the plan is properly addressing the creditors’ rights.
    • First, only a debtor may file a plan of reorganization. Creditors cannot file a competing plan, which eliminates some of the leverage secured creditors have historically enjoyed.
    • Second, the SBRA does not require the debtor to file a disclosure statement. The disclosure statement has historically been a source for useful information that creditors can analyze to understand the debtors’ intentions and prospects for reorganization.  Under the SBRA, the debtor needs to only provide a brief description of the business, a liquidation analysis, and projections of the debtor’s ability to make payments under the plan. Therefore, it will be incumbent upon the creditor to gather and request, if necessary, any additional information needed for the creditor to fully understand the debtors’ plan and ability to reorganize.
    • Third, the SBRA now allows confirmation even if no impaired class of creditors votes in favor of the proposed Plan. In other words, small business owners may now get to keep their business even if a secured creditor, holding a large unsecured deficiency claim, does not vote in favor of the plan.  To confirm such a plan the debtor must prove that the plan is “fair and equitable” to the unsecured claimant.  By code, a plan is deemed “fair and equitable” as long as it pays all of the debtor’s projected disposable income (or property) to creditors for a three to five-year period of time.  How a debtors’ “projected disposable income” is calculated will be a subject of great debate over the coming years, and the subjective nature of the calculation can provide a dissatisfied creditor holding a deficiency claim with some leverage over the debtor.  Accordingly, it is critically important that the creditor analyze a debtor’s proposed plan, and specifically the manner in which the debtor has determined its projected disposable income, to ensure the highest recovery is afforded to the creditor.
  • Debtors’ Right To Modify Claim Secured By Mortgage – The SBRA also allows sole proprietor debtors to modify certain residential mortgages by permitting a debtor to strip a mortgage that is under-secured. To be eligible for this modification, the debtor must show that the loan was not incurred to acquire the residence and the proceeds of the loan were used in connection with the debtor’s business.
  • Introduction of the Subchapter V Trustee – Under the SBRA, the US Trustee appoints a “Subchapter V Trustee” to investigate and monitor the debtors’ case.  Creditors should be aware, that unlike the role of U.S. Trustees in a normal Chapter 11 case, a Subchapter V Trustee’s role is to serve more as an intermediary between the debtor and its creditors, as opposed to a trustee who is acting in the interests of creditors.  As such, creditors should not rely on the Trustee to be overly critical of the debtors’ case and/or assume that the Trustee is investigating the debtors’ case in an exhaustive manner.  The Trustee’s role is to attempt to facilitate a compromise between the debtors and their creditors.

If you have questions about these changes to bankruptcy law, or its application to specific customer circumstances, please contact Lauren R. Goodman or James J. Niemeier McGrath North’s Insolvency, Restructuring, and Bankruptcy Group.

[1] The increased debt limit of $7,500,000 will remain in effect until it is scheduled to sunset on or around March 27, 2021.   It is possible that Congress may act to extend the increased debt limit, but its willingness to do so has not yet been determined.