The Small Business Reorganization Act of 2019 (SBRA)

 

Effective February 22, 2020

In 2019, Congress amended the United States Bankruptcy Code by enacting the Small Business Reorganization Act (the SBRA). One of the most important features of the SBRA is the creation of a new bankruptcy option for small businesses, Subchapter V of chapter 11 of the Bankruptcy Code.  Subchapter V is designed to streamline the chapter 11 process and remove some of the challenges for small businesses seeking to reorganize through bankruptcy. See, e.g., Statement of Senate proponents of SBRA.

Initially, Subchapter V was available to debtors with aggregate secured and unsecured debt of no more than $2,725,625.  11 U.S.C. § 101(51D).  However, as part of the CARES Act, signed into law March 27, 2020 as an emergency response to the COVID-19 pandemic, for one year the debt limit has been increased to $7,500,000, opening these provisions to a broader segment of businesses.  See H.R. 748, section 1113.

Some of the major features of Subchapter V include:

1.  Chapter 11 Plan Filed Within 90 Days After the Bankruptcy Filing, And Only Debtor May Propose A Plan. This is different from a typical chapter 11, where the debtor has the exclusive right to file a plan for the first 120 days, and that exclusive right may be extended for up to 18 months if the court finds “cause.”  Once exclusivity expires, other parties may submit a plan.  Eliminating the costs and risk associated with plans being proposed by competing parties, Subchapter V provides that only the debtor may submit a plan.  11 U.S.C. § 1189(a).  Further, Subchapter V requires that the plan be filed within 90 days after the filing of the petition, shortening the length of time in bankruptcy court.  11 U.S.C. § 1189(b).  And an extension is only allowed “if the need for the extension is attributable to circumstances for which the debtor should not justly be held accountable.”  11 U.S.C. § 1189(b). Among other key requirements, unless all classes of creditors vote in favor of the plan, the plan must pay creditors an amount equal to its projected disposable income over a three to five year period.  11 U.S.C. § 1191(c)(2)(A).

2.  Owners May Keep Equity in Company (No Absolute Priority Rule). The absolute priority rule in chapter 11 requires that owners contribute new value to keep their equity in the reorganized company.  That requirement is expressly eliminated from Subchapter V, removing a major financial cost and risk from the reorganization process.  11 U.S.C. § 1181(a).

3.  Discharge. If a plan is consensual (meaning, all classes of creditors vote in favor of it), the debtor will receive a discharge upon confirmation.  If the plan is not consensual, and if the debtor makes its required plan payments, its remaining debts are discharged.  11 U.S.C. § 1192.

4.  Trustees. All Subchapter V cases have a trustee, a professional fiduciary, who oversees the case.  11 U.S.C. § 1183.  The trustee’s role includes investigating the business and financial affairs of the debtor, and may include distributing plan payments.  This role is more limited than the role of a chapter 7 trustee or that of a trustee appointed in chapter 11 case for cause.  Unlike those situations, in Subchapter V the debtor stays in control of its business operations.  That is, the debtor remains a “debtor in possession” unless removed for “cause, including fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor.”  11 U.S.C. § 1185.

5.  No Disclosure Statement is Required Unless Ordered by the Court for Cause. In a typical chapter 11, the debtor is required to prepare a “disclosure statement” which the court reviews for adequacy of information as a preliminary step before the plan can be voted on by creditors and confirmed by the court.  This is one of the factors that contributes to the time and expense of a typical chapter 11 case.  Subchapter V eliminates that step from the process unless ordered by the court for cause.  11 U.S.C. § 1181(b).

6.  No Creditors’ Committee. Creditors’ Committees can play an important role in chapter 11 cases.  The committee allows creditors to advocate collectively for the best interests of all of the general unsecured creditors (or other classes of creditors or interest holders).  However, it is also sometimes cited as a major expense that prevents small businesses from utilizing and successfully emerging from chapter 11.  Subchapter V eliminates committees from the process, unless expressly ordered by the court in the case.  11 U.S.C. § 1181(a).

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Nationwide Bankruptcy Courts Allow Amendment of Petitions to Streamlined Reorganization under Subchapter V of Chapter 11

Courts throughout the country are broadly permitting amendment of bankruptcy petitions filed prior to the effective date of the Small Business Reorganization Act (“SBRA”) to Subchapter V of Chapter 11.

Here is a discussion of four cases reaching this conclusion.

In re Progressive Sols., Inc., No. 8:18-bk-14277-SC, 2020 WL 975464 (Bankr. C.D. Cal. Feb. 21, 2020).

Debtor may amend its petition in a case filed prior to enactment of SBRA.  The debtor sought authority to amend the case from a small business chapter 11 case to a subchapter V small business debtor case (lest there be confusion, a “small business case” is a small business chapter 11 case that is not a “subchapter V” case.  11 U.S.C. § 101(51C)).  The case was first filed on November 21, 2018 as a small business chapter 11 case.  At a hearing on February 20, 2020, the day after the SBRA became effective, the debtor asked that the petition be re-designated a subchapter V “small business debtor” petition.  The court ruled that the amendment can be made at any time without leave of court pursuant to FRBP 1009(a).

In re Moore Props. of Pers. Cty., LLC, No. 20-80081, 2020 WL 995544 (Bankr. M.D.N.C. Feb. 28, 2020).

On February 10, 2020, nine days before the effective date of SBRA, the debtor filed a small business chapter 11 case.  A creditor immediately objected because the debtor was the owner of three real properties, and its primary activity was the business of owning or operating real estate, making the debtor ineligible for designation as a “small business debtor” under then language of 11 U.S.C. § 101(51D).  Five days after the effective date of SBRA, the debtor filed an amended petition to one under subchapter V.  The court authorized the amendment in light of SBRA’s revision to section 101(51D).  That statute used to say that a debtor whose primary activity is the business of owning or operating real estate is not a “small business debtor,” but now the exception applies to a debtor who operates “single asset real estate.”  Here the debtor owned three separate properties, each leased for third party farming operations, so it was not a single asset real estate debtor.  At the time of the hearing the “small business debtor” designation was correct and the debtor was entitled to amend as of right under FRBP 1009.

In re Body Transit, Inc., No. BR 20-10014 ELF, 2020 WL 1486784 (Bankr. E.D. Pa. Mar. 24, 2020).

Citing the two cases discussed above, the court agreed that the debtor has the right to amend its petition.  Further, it determined that the standard applicable to a creditor’s objection is whether the creditor will be prejudiced by the amendment or whether the amendment is made in bad faith.  Because the objecting creditor did not satisfy its burden of proof, the court overruled the objection and approved the amendment.

In re Bello, No. 19-46824, 2020 WL 1503460 (Bankr. E.D. Mich. Mar. 27, 2020).

An individual case was originally filed under chapter 13, then converted to chapter 11 and, finally, after the effective date of SBRA, the debtor amended the petition to one under Subchapter V.  Applying Moore, the court approved the amendment.

Supreme Court Copyright Decision that is Important for Bankruptcy Practitioners

 

Allen v. Cooper, 589 U.S. ___, 2020 WL 1325815 (2020)

On March 23, 2020, the United States Supreme Court struck down the Copyright Remedy Clarification Act of 1990 (“CRCA”), holding that Congress had no authority under either Article I of the U.S. Constitution or Section 5 of the Fourteenth Amendment to abrogate sovereign immunity for States that infringe on protected copyrights.  Allen v. Cooper, 589 U.S. ___, 2020 WL 1325815 (2020).  To read the full decision, click here.

While the demise of the CRCA may not at first blush appear relevant to bankruptcy practitioners, the Court’s opinion includes a discussion with significant implications for the practice of Bankruptcy law.  Plaintiff in Allen v. Cooper asked the Court to adopt the ruling in Central Virginia Community College v. Katz, 546 U.S. 356 (2006), finding that Congress either had the authority to abrogate state sovereign immunity with regard to copyright claims or that the States waived their sovereign immunity rights as to intellectual property at the time of the plan of the Constitutional Convention.  Namely, Allen asked the Court to hold that the States understood in 1789 that Article I of the Constitution gave Congress the authority to codify uniform laws affecting copyrights and patents, including the authority to bind the States in federal courts as to these laws.

Despite expectations by some legal commentators that the Court in Allen v. Cooper would reject Allen’s argument and signal a future overturning of Katz, the Court affirmed that the Bankruptcy Clause is “unique” among Article I Clauses, suggesting that the Supreme Court would likely affirm Katz in future cases involving the Bankruptcy Clause.

Reversal of Katz would have a significant impact on bankruptcy proceedings in the United States, as it would deprive bankruptcy court jurisdiction over the States in many circumstances.  States are major creditors in bankruptcy cases, so their ability to assert sovereign immunity would likely change the bankruptcy landscape.

Bankruptcy Court Holds Unscheduled Claim Is Not Discharged

West Valley Medical Partners, LLC v. Menaker (In re Menaker), __B.R.__, No. 1:13-BK-13562-MB, 2019 WL 3064875 (Bankr. C.D. Cal. July 8, 2019).

The defendant-debtors leased commercial property form the plaintiff creditor prior to their bankruptcy filing.  They vacated the premises more than three years before the end of the lease term and then filed a voluntary chapter 13 petition.  They did not schedule the plaintiff’s claim or give it notice of the bankruptcy filing or the deadline to file a claim.  Their plan was confirmed and did not include any payments to plaintiff.  Plaintiff filed a complaint for breach of the lease in state court.  The defendants thereafter amended their schedules to add plaintiff as an unsecured creditor.  The defendant-debtors obtained their discharge and the case was closed.  The plaintiff moved to reopen the case to obtain a determination that its claim was not dischargeable under section 523(a)(3)(A) of the Bankruptcy Code.

Section 523(a)(3)(A) provides that a claim is not dischargeable if it is “neither listed nor scheduled … in time to permit . . . timely filing of a proof of claim, unless such creditor had notice or actual knowledge of the case in time for such timely filing.”

The court overruled the debtors’ equitable arguments, allegations of actual knowledge, and their laches defense.  Based on a plain reading and application of the statute, the court ruled in favor of the plaintiffs, holding the claim nondischargeable under section 523(a)(3)(A).

Bankruptcy Court Rules that Federal Energy Regulatory Commission Does Not Have Concurrent Jurisdiction Over Rejection of Power Purchase Agreements

PG&E Corp. v. Fed. Energy Reg. Comm’n (In re PG&E Corp.), No. AP 19-03003, 2019 WL 2491247 (Bankr. N.D. Cal. June 7, 2019).

The debtors filed an adversary proceeding seeking a judgment enjoining the Federal Energy Regulatory Commission from impacting the debtors’ ability to reject power purchase agreements and related relief.

Shortly after the debtors announced their intent to file for bankruptcy protection, power purchase agreement counterparties filed administrative proceedings with the Federal Energy Regulatory Commission seeking a ruling that FERC must approve rejection of a PPA.  On Janaury 25 and 28, 2019, FERC ruled that it has concurrent jurisdiction with the bankruptcy court to consider rejection of PPAs.  On January 29, 2019, the debtors filed their voluntary bankruptcy petitions.  On the petition date, the debtor aslo filed an adversray proceeding for decalaratory and injunctive relief barring FERC from impacting the debtors’ ability to reject PPAs.  In its detailed analysis, the bankruptcy court stated unequivocally that there is no concurrent jurisdiction between FERC and the bankruptcy court with respect to rejection of executory contracts.  Pursuant to 28 U.S.C. §§ 157(b)(2) and 1334(a), the bankruptcy court has the exclusive authority and jurisdiction over the rejection of executory contracts under section 365 of the Bankruptcy Code, including PPAs.

Criminal Conviction Evidenced a Lack of Good Faith in Student Loan Dischargeability Action

In re Hurley, 601 B.R. 529 (B.A.P. 9th Cir. 2019).

The debtor incurred student loan debt while studying for his law degree and L.L.M. in taxation.  In 2009 he was hired as a revenue agent for the IRS.  In 2016, he was criminally convicted for receiving a bribe in his role as an IRS agent.  He was sentenced to 30 months in prison followed by three years of supervised release.  He was disbarred.  Upon his release from prison, the debtor lived in a halfway house in Seattle.

After his conviction, the debtor filed a chapter 7 petition.  The debtor had approximately $256,000 in student loan debt.  He filed a complaint, from prison, seeking to discharge his student loan debt.  He argued that, under section 523(a)(8) of the Bankruptcy Code, the debt should be discharged because it imposed an undue hardship.  The debtor claimed that because of his conviction, incarceration, and disbarment, he would be unable to regain employment at his previous level, and would therefore be unable to pay his debt.  He was 45 years old with a three-year-old child, but did not claim to have medical or other conditions preventing him from working.  The defendants (the government and lender) filed a motion for summary judgment. The defendants’ motion for summary judgment was granted based on a finding that the debtor did not establish that he made a good faith effort to repay the loans.

The debtor appealed to the Bankruptcy Appellate Panel.  The BAP affirmed.  Under section 523(a)(8) of the Bankruptcy Code, a student loan is not dischargeable unless the debtor establishes that repaying the debt would “impose an undue hardship on the debtor and the debtor’s dependents.”  The Ninth Circuit has adopted the three-pronged Brunner test to determine whether a debtor has established undue hardship: (1) that the debtor cannot maintain, based on current income and expenses, a minimal standard of living for herself and dependents if forced to repay the loans; (2) additional circumstances exist indicating that this state of affairs is likely to persist for a significant portion of the repayment period; and (3) the debtor has made good faith efforts to repay the loans. Brunner v. N.Y. State Higher Educ. Servs. Corp. (In re Brunner), 46 B.R. 752, 756 (S.D.N.Y. 1985), aff’d, 831 F.2d 395, 396 (2d Cir. 1987) (adopted by United Student Aid Funds, Inc. v. Pena (In re Pena), 155 F.3d 1108, 1111-12 (9th Cir. 1998)).

The BAP agreed with the bankruptcy court’s finding that the debtor’s criminal conduct was not a factor beyond his reasonable control, and the bankruptcy court did not err by taking it into consideration.  However, the BAP was careful to avoid setting a “bright-line rule that a debtor with a criminal conviction can never establish good faith.”  The BAP and the trial court noted that the debtor did make reasonable efforts to repay the debts, but that the balance of factors still weighed against the requisite finding of good faith.

Supreme Court Sets Standard for Civil Contempt for Violation of Discharge Order

Taggart v. Lorenzen, 139 S. Ct. 175 (2019).

The Supreme Court held that a court may hold a creditor in civil contempt for violating a discharge order if there is “no fair ground of doubt” as to whether the order barred the creditor’s conduct.  That is, there is no objectively reasonable basis for concluding that the creditor’s conduct might be lawful.

The debtor was a defendant in state court litigation prior to his chapter 7 bankruptcy filing.  The debtor obtained a discharge in his bankruptcy case.  Thereafter, the state court entered judgment against the debtor and the creditor-plaintiff applied to the state court for attorneys’ fees incurred after the debtor-defendant filed his bankruptcy petition.  The state court found that the debtor had “returned to the fray” after the bankruptcy filing, justifying an award of postpetition attorneys’ fees under the Ninth Circuit precedent of In re Ybarra, 424 F.3d 1018 (9th Cir. 2005).

The debtor sought a bankruptcy court order barring the creditor from collecting postpetition attorneys’ fees and holding the creditor in civil contempt.  The bankruptcy court denied the debtor’s request, finding, like the state court, that the debtor returned to the state court “fray.”  The district court reversed and remanded.  On remand, the bankruptcy court applied a standard likened to “strict liability.”  It found that civil contempt sanctions were appropriate because the creditor was “aware of the discharge” order and “intended its actions which violated” it.  The creditor appealed.  The BAP vacated the sanctions and the Ninth Circuit affirmed the BAP.  The Ninth Circuit held that “a ‘creditor’s good faith belief’ that the discharge order ‘does not apply to the creditor’s claim precludes a finding of contempt, even if the creditor’s belief is unreasonable.’”

The Court began its analysis with two applicable Bankruptcy Code provisions.  Section 524(a)(2) states that a discharge order serves as an “injunction against the commencement or continuation of an action” among other things.  Section 105(a) authorizes the court to “issue and order…necessary or appropriate to carry out the provisions” of the Bankruptcy Code.  The Court explained that its “conclusion rests on a longstanding interpretive principle: When a statutory term is ‘obviously transplanted from another legal source’ it ‘brings the old soil with it.’”  Here, the “‘old soil’ includes the ‘potent weapon’ of civil contempt.”  Such power is limited by the “traditional standards in equity practice.”  In nonbankruptcy cases, civil contempt is not employed when there is a “fair ground of doubt as to the wrongfulness” of conduct.  This requires application of an objective reasonableness standard.  The Ninth Circuit erred when it applied a subjective standard for civil contempt.  The judgment was thus reversed and the case remanded.

 

Family Law and Bankruptcy—Dischargeability of Debts Assigned to Spouse in Marriage Settlement Agreement

In re Carrion, __ B.R. __  (B.A.P. 9th Cir. May 31, 2019).  During marriage, the debtor borrowed $21,894 from the U.S. Department of Education to pay tuition for his son’s college education.  His wife later filed a petition for dissolution of marriage and, around the same time, they filed a joint chapter 7 petition.  In their marriage settlement agreement, husband and wife both agreed to be liable for half of the education loan.  Husband later filed a lawsuit against the department of education asserting that the educational loan was void because wife obtained it through identity theft.  The bankruptcy court rejected the identity theft argument and ruled that the husband’s one half of the educational loan was nondischargeable under 11 U.S.C § 523(a)(8).  The Department appealed to the Bankruptcy Appellate Panel for the Ninth Circuit, arguing that the full amount of the educational loan was nondischargeable.  The BAP agreed with the Department and reversed.  The BAP reasoned based on Cal. Fam. Code § 916(a)(1), which provides that after division of community property: “[t]he separate property owned by a married person at the time of the division and the property received by the person in the division is liable for a debt incurred by the person before or during marriage and the person is personally liable for the debt, whether or not the debt was assigned for payment by the person’s spouse in the division.”  The marriage settlement agreement did not eliminate the debtor husband’s liability to the creditor.  The entire debt was owed by the husband.

Bankruptcy Case Involving Marijuana Related Business

Garvin v. Cook Investments NW, SPNWY, LLC, 922 F.3d 1031 (9th Cir. 2019). The U.S. Trustee argued that a chapter 11 plan was “proposed by …means forbidden by law” because one of five debtors’ income was from lease of its real property to a marijuana grower.  Debtors and property were located in Washington state in which marijuana is legal.  Leasing property to a marijuana grower is illegal under federal law.  The debtors proposed a plan providing for payment of their creditors’ claims in full and, in turn, creditors fully supported the plan.  The U.S. Trustee objected to confirmation because it asserted that the plan was “proposed by…means forbidden by law,” thus not satisfying the requirement of 11 U.S.C. § 1129(a)(3).  The bankruptcy court overruled the objection and confirmed the plan, and the district court affirmed.  On appeal, the Ninth Circuit affirmed, holding that 1129(a)(3) requires that the debtor comply with the law in how it proposes the plan, not that the terms of the plan comply with nonbankruptcy law in all respects.  This case suggests that, while the bankruptcy courts may generally still be inaccessible to most marijuana businesses, there may be some marijuana “adjacent” businesses that can benefit from bankruptcy relief.

Some Lessons Learned from In re Pacific 9 Transportation, Inc.

In 2018, Danning, Gill, Diamond & Kollitz, LLP, concluded its representation of the Official Committee of Unsecured Creditors appointed in In re Pacific 9 Transportation, Inc., Bankr. Case No. 2:16-bk-15447-WB (Bankr. C.D. Cal.). The case presented a number of interesting issues that continue to plague trucking companies operating out of Los Angeles ports.

The debtor was an intermodal trucking company engaged in the transport of shipping containers from the Ports of Los Angeles and Long Beach to nearby destinations. Prior to bankruptcy, all of the debtor’s truck drivers were hired as “owner operators,” paid as independent contractors, rather than as employees. Like many other trucking companies in the last several years, the debtor was sued by former workers for violations of California employment laws, particularly for the misclassification of its employees as independent contractors and violations of wage and hour laws. A class action and numerous individual actions were filed against the debtor. Dozens of individual employees obtained, or were on track to obtain, labor commissioner awards and judgments against the debtor. Although the debtor attempted to settle with the class action plaintiff, the number of potential class members who opted out of the class made a class action resolution infeasible. Faced with tens of millions of dollars in liabilities, the debtor filed a chapter 11 bankruptcy petition.

A creditors’ committee was quickly formed and shortly thereafter the committee selected DGDK as its general counsel. The committee was comprised of truck drivers in varying positions, including the class action plaintiff, individual plaintiffs who had already obtained awards against the debtor, and those whose claims were still in progress. The committee acted swiftly to investigate the debtor’s business and financial affairs.

The committee actively participated in the case to ensure not only that the debtor complied with its duties under the Bankruptcy Code, but that it also engaged in lawful employment practices under California law. During the case, the debtor started to transition from its prior “owner operator” business model to a business model reliant on employee drivers. The transition was not easy. Among other things: consistent with its prior employment model, the debtor did not own very many trucks; there was a shortage of qualified truck drivers; and ironically, despite the fact that some former employees were suing the debtor for not treating them as employees, the debtor reported that many current drivers were reluctant to change to employee status and preferred to be treated as independent contractors. Making matters worse, the debtor was at a competitive disadvantage against competitors that continued to use the independent contractor model. Moreover, negative publicity from the labor disputes resulted in a loss of business and revenue necessary to fund a successful reorganization.

The committee initially opposed a plan that insufficiently addressed the debtor’s legal problems and did not provide adequate payment to its creditors. However, after extensive negotiations with the debtor and among the creditor constituents, the committee and the debtor succeeded in jointly confirming a plan of reorganization that resulted in payment of millions of dollars to the debtor’s creditors. The plan became effective in January 2018.

A few observations regarding the committee’s efforts to achieve a chapter 11 plan that was in the best interests of creditors:

  • Before the bankruptcy, the truck drivers comprising the committee successfully litigated their employee misclassification claims against the debtor. However, after bankruptcy, the committee members were necessarily focused on maximizing financial recoveries to all creditors. The debtor indicated that converting to an employee-based model would be difficult and costly, suggesting there may be a misalignment between the committee members’ economic and adjudicated interests. Ultimately, however, the debtor needed to convert its business model to confirm a feasible plan and to successfully reorganize. The committee vigorously encouraged that process, which proved effective for all parties.
  • Outside of bankruptcy, creditors often compete for a debtor’s assets. Bankruptcy is intended to stop the “race to the courthouse.” In bankruptcy, unsecured creditors share in the same pool of funds. Thus, it is in the best interest of all creditors to maximize the debtor’s assets and, thereby, the overall distribution to creditors. Here, through the committee, the creditors united to achieve a maximum recovery and, at the same time, negotiated among themselves for a mutually agreeable distribution among differently situated truck driver creditors—class action members versus individually represented plaintiffs. This approach ensured a fair outcome with a substantial dividend to all creditors.