By Matt Daus
Editor’s note: This article is part of Matt Daus’ article in the February 2021 issue entitled Buy, Sell, Retire? Weighing Your Post-Pandemic Options. Daus discusses the pathways available to transportation operators now and in the future as the virus continues to stymie travel and transportation.
Bankruptcy is a viable option for those that just don’t see any other way through, and it doesn’t necessarily mean closing the doors (although that’s a possibility, too). There are two primary types of business bankruptcy cases: Chapter 7 (liquidation) and Chapter 11 (reorganization). Within Chapter 11 there are a number of subcategories, including new Subchapter V, which includes game-changer benefits for small business debtors.
Liquidation: Chapter 7 of the Bankruptcy Code
Chapter 7 of the Bankruptcy Code provides for the orderly and equitable liquidation and distribution of non-exempt assets of the debtor. In exchange, an “individual” debtor will receive a discharge. Corporations and partnerships, which are not individuals under the Bankruptcy Code, do not receive discharges under Chapter 7. Instead, the corporate shell is left with debts, but no assets. A corporation seeking a discharge must file Chapter 11 and confirm a Chapter 11 plan.
At the commencement of a Chapter 7 case, a “panel” trustee is appointed by the Office of the United States Trustee to serve as Chapter 7 trustee of the debtor’s bankruptcy estate. Pursuant to Section 704 of the Bankruptcy Code, the Chapter 7 trustee takes over full control of the debtor’s assets and is charged with collecting the property of the debtor’s estate and closing such estate as expeditiously as is compatible with the best interests of the parties in interest. Where the debtor is a business entity, the trustee may seek authorization of the court to temporarily operate the debtor’s business if it would be in the best interest of the estate.
Reorganization: Chapter 11 of the Bankruptcy Code
The purpose of Chapter 11 is to permit the debtor to continue to operate while it reorganizes its business and capital structure pursuant to a court-approved plan of reorganization. The Chapter 11 debtor is known as a “debtor in possession” because, unlike in a Chapter 7 case, the debtor remains in possession of the estate assets. Chapter 11 can also be used when management seeks to conduct an orderly liquidation of the debtor’s business, including a sale of substantially all of the debtor’s assets under a Chapter 11 plan or a sale outside of a plan pursuant to section 363 of the Bankruptcy Code, because it avoids the appointment of a panel trustee and the “fire sale” climate. Whether used for a reorganization or a liquidation, Chapter 11 is a valuable tool that allows a debtor to preserve its business and thereby maximize value for all creditors. A highlight of some of the key provisions of Chapter 11 is below.
Procedural Overview of Chapter 11 Proceedings
The goal of a Chapter 11 case is the consensual confirmation of a plan of reorganization or plan of liquidation. As discussed in further detail below, Chapter 11 plans must satisfy the requirements of the Bankruptcy Code to be approved or confirmed. After the plan is confirmed, the debtor is required to make plan payments or distributions and is bound by the plan’s provisions. The confirmed plan creates new contractual rights and can create, replace, or supersede pre-bankruptcy contractual rights. Both prepetition and post-petition creditor claims are satisfied as set forth in the plan, and upon consummation, the debtor receives a discharge of any debt that arose before the date of confirmation. However, confirmation of a Chapter 11 plan does not discharge the debtor if the plan is a liquidation plan.
Under Chapter 11, the debtor is authorized to and generally continues to operate the business in the ordinary course without bankruptcy court approval. Pursuant to Section 1104 of the Bankruptcy Code, on the request of a party in interest, the court shall appoint a Chapter 11 trustee for cause, including fraud, dishonesty, incompetence, or gross mismanagement, either before or after the bankruptcy filing, or where appointment of a trustee is in the best interest of the parties in interest. Generally, courts will not appoint a Chapter 11 trustee absent a showing of fraud or gross mismanagement.
Key Benefits of Chapter 11
The Automatic Stay: Debtors file for bankruptcy protection for myriad reasons, but a principal reason is that the filing provides the debtor with immediate protection from a wide variety of efforts to collect on debts that arose before the bankruptcy petition was filed. Pursuant to Section 362 of the Bankruptcy Code, the filing of a Chapter 7 or Chapter 11 bankruptcy petition (as well as petitions under certain other chapters of the Bankruptcy Code) operates as a stay, applicable to all entities, of a wide range of acts to collect on debts that arose before the bankruptcy petition was filed. The automatic stay is intended to provide a debtor with a breathing spell during its bankruptcy case. If a creditor violates the automatic stay, a bankruptcy court may hold the creditor in contempt of court and award the debtor compensatory damages. In addition, where the violation is willful, the bankruptcy court may award punitive damages.
Sale-Related Provisions: Although a debtor is authorized to operate its business, it may not sell, use, or lease property of the estate outside of the ordinary course of business without court approval. A sale of assets outside the ordinary course of business, including a sale of substantially all of a debtor’s assets, may be approved as part of a Chapter 11 plan under Section 1123 of the Bankruptcy Code or prior to a plan under Section 363 of the Bankruptcy Code. When assets are sold in bankruptcy, the assets are typically sold free and clear of all liens, claims, and interests with any liens and interests attaching to the proceeds of the sale with the same priority they had at the time of the sale.
Advantages of Effectuating a Sale: There are a number of key advantages to effectuating a sale through a Chapter 11 bankruptcy process, which includes:
- There is a reduced risk of later challenges, including a fraudulent conveyance.
- This form of sale is favored by directors who have no financial stake in the game.
- Assets can generally be sold free and clear of liens, claims, and encumbrances (including successor liability claims) and over objections by shareholders and creditors.
- Executory contracts in default can be cured, assumed, and assigned, even if the contract provides otherwise—although there are exceptions, such as certain intellectual property contracts.
- Executory contracts can be rejected—provides ability for purchasers to cherry-pick which contracts they want to acquire.
- There can be avoidance of transfer taxes if sold through a plan, which can be a significant benefit, especially where real estate is involved.
Small Business Debtors: Subchapter V
Special rules also apply with respect to small business debtors. As of February 20, 2020, newly enacted Subchapter V of Chapter 11 became effective. Subchapter V modifies certain longstanding provisions of Chapter 11 with respect to certain small business bankruptcy cases. The recently enacted rules applicable to small business debtors are very favorable to a debtor and debtors will try to find ways for the small business bankruptcy rules to be made applicable to them. Subchapter V currently applies to debtors with aggregate non-contingent liquidated secured and unsecured debts not more than a specified threshold. Prior to the CARES Act, the threshold was approximately $2.7 million (excluding debts owed to insiders and affiliates), which increased the threshold to $7.5 million. However, this increased threshold for the amount of debt to qualify for Subchapter V is scheduled to revert back to $2.7 million on March 27, 2021, absent an extension by Congress. In reviewing the Biden administration’s legislative priorities and proposals, an extension of the March 27 deadline before the higher threshold terminates is unlikely. Therefore, eligible financially distressed businesses should give serious consideration to taking advantage of the new law before the program reverts back to the lower threshold.
Differences Between Subchapter V and Traditional Chapter 11
Subchapter V of Chapter 11 provides numerous advantages when compared to a traditional Chapter 11 bankruptcy filing, including:
- The trustee will typically appoint a small business trustee, and there will be no creditors’ committee, which is more direct and avoids the costs of a creditors’ committee.
- In most cases, under Subchapter V, the debtor transportation company will continue to manage the business operations.
- In a Subchapter V case, the “absolute priority rule” does not apply, which generally requires that creditors be paid in the order of their priority. Instead, Subchapter V allows equityholders to retain their equity even if unsecured creditors have not been paid in full.
- There is no obligation to use excess post-bankruptcy petition income for 3-5 years to fund plan payments to creditors if fully consensual.
- There is no obligation to employ and pay fees of Subchapter V trustee to make plan payments if fully consensual.
- Administrative claims can be paid over time rather than all at once upon plan confirmation, as is the case in a traditional Chapter 11 case. This change will be of particular benefit to any transportation company-debtor with significant administrative claims.
- There also may be a greater ability to pay contract and lease cure costs over time in connection with a contract and lease assumption.
Procedural Benefits: Several procedural differences/benefits of Subchapter V over traditional Chapter 11 include:
- There is no obligation to file a separate disclosure statement in connection with the Chapter 11 plan, which saves time and costs.
- The debtor retains exclusive ability to file and confirm a Chapter 11 plan and creditors have no ability to strip the debtor of that right. In a traditional Chapter 11, the debtor retains the exclusive right to file a plan for only a limited timeframe and other parties can attempt to shorten that timeframe.
- The trustee is accountable for all property received, will examine proofs of claim, controls plan distributions if nonconsensual plan, and has a fee equal to 5 percent of receipts.
- Unsecured creditors’ committees will be very rare in Subchapter V cases. The committee can result in considerable cost savings given that a debtor typically pays for all of the fees and expenses of the committee’s professionals, including attorneys and financial advisors.
Strategic Advantages: Subchapter V strategic considerations for a debtor include:
- The ability to pay down debt prior to a filing to become eligible for Subchapter V.
- The transportation company-debtor may spin off certain assets/liabilities into a separate legal entity in order to make one or both entities eligible for Subchapter V.
- There is a greater opportunity to propose a sale of all assets to a favored party without a bidding process or creditor consent. Traditional Chapter 11 limits the ability of a debtor to do so under a Chapter 11 plan because (1) creditors can seek to terminate plan exclusivity and submit a completing plan, and (2) at least one impaired creditor class must approve the plan even when it is a “cram down” plan.
Given the numerous substantive, procedural and strategic benefits that a Subchapter V bankruptcy case provides when compared to a traditional Chapter 11 case, transportation operators that are facing insurmountable debts may want to consider the Subchapter V option now since the more generous provisions under the CARES Act that increases the debt limit to $7.5 million will expire—absent action by the Biden administration and Congress—on March 27, 2021.
Matt Daus is a partner with the law firm Windels Marx, president of IATR, and a leading authority on ridesharing apps. He can be reached at email@example.com.