When to File Subchapter V Bankruptcy Instead of Chapter 11 ?

Key Takeaways: Subchapter V of Chapter 11 Bankruptcy

1. Bankruptcy reorganization provides relief to businesses and individuals facing overwhelming obligations to lenders, landlords, taxing authorities, judgment holders, or trade creditors.

2. In California, businesses can choose between traditional Chapter 11 proceedings or the recently enacted Sub-Chapter V of Chapter 11 for reorganization.

3. Sub-Chapter V differs from traditional Chapter 11 in terms of the role of trustees. In Sub-Chapter V, an independent trustee is appointed to assist the debtor and creditors in reaching a consensual plan of reorganization.

4. Unlike traditional Chapter 11 cases, Sub-Chapter V cases do not involve the appointment of a creditors’ committee, reducing costs for the debtor.

5. Traditional Chapter 11 cases require the approval of a disclosure statement, which can be time-consuming and costly. However, Sub-Chapter V cases do not require a disclosure statement.

6. The Absolute Priority Rule, which posed challenges for small business owners, is eliminated in Sub-Chapter V, making it easier for them to reorganize their businesses.

7. In traditional Chapter 11 cases, fees must be paid to the Office of the United States Trustee (OUST), while Sub-Chapter V cases do not require OUST fees.

8. Not all troubled businesses qualify for Sub-Chapter V, and navigating its complexities requires expertise in Chapter 11 cases. Consulting an experienced bankruptcy attorney is crucial in determining the most suitable bankruptcy option.

1. The Different Kinds of Trustees

First, some key terms. The term “trustee” has multiple meanings in bankruptcy parlance. In Chapter 7 cases (not the subject of this post), the trustee is an individual—usually an independent lawyer or accountant—appointed to collect and sell the debtor’s assets in order to pay the proceeds to creditors based on the amount and priority of their allowed claims.

Unlike in a Chapter 7 case, in a traditional Chapter 11 case, there is typically no trustee in charge of collecting or selling assets or handling the debtor’s affairs. Rather, the debtor itself remains in charge of its affairs as a “debtor-in-possession” or “DIP.” The exception is if the court determines that the DIP is untrustworthy or incapable of fulfilling its fiduciary obligations as a DIP. Should that happen, the court may appoint a Chapter 11 trustee to take over the administration of the case and to decide if the case should be “converted” to a liquidation case under Chapter 7 of the bankruptcy code.

In a Sub-Chapter V case, an individual trustee (again, typically an independent lawyer or accountant) is appointed but to fulfill a very different purpose than in Chapter 7 business bankruptcy or Chapter 11. The job of a Sub-Chapter V trustee is to help the debtor and its creditors to reach agreement on the substance of a Chapter 11 plan. Unless and until the court removes the debtor on account of fraud, dishonesty, or gross mismanagement either before or after the commencement of the case, the Sub-Chapter V trustee serves only as a liaison or facilitator, charged with giving the court his or her perspective on the case and helping the parties achieve a consensual plan of reorganization, if possible.

In all bankruptcy cases, the United States Trustee or “UST” (sometimes called the Office of the United States Trustee) is responsible for appointing and overseeing the individual trustees in all the bankruptcy cases filed under every chapter in a particular district. The UST is an appointee of the United States Department of Justice. In California, the UST appoints and oversees the individual trustees in the counties of Los Angeles, Orange, Riverside, San Bernardino, Ventura, and Santa Barbara. In Chapter 11 cases, the UST ensures the DIP complies with its myriad fiduciary duties, like closing pre-bankruptcy bank accounts, opening new DIP accounts at an approved institution, carrying appropriate insurance, and filing Monthly Operating Reports or “MORs.”

2. The Appointment of a Creditors’ Committee

In drafting the bankruptcy code, Congress understood that it might be impractical for individual creditors in larger cases to hire their own attorneys to look after their own interests. So the Bankruptcy Code provides for the UST to appoint a creditors’ committee. A creditors’ committee is made up of holders of general unsecured claims, who collectively hire a lawyer at the debtor’s expense, to look after the interests of similarly situated creditors. The committee’s job is to look out for the interests of its constituents and negotiate on their behalf a plan of reorganization with the debtor. While the UST may choose not to appoint a creditors’ committee in particular cases, when it does, it can add to the significant cost of traditional Chapter 11 bankruptcies.

By contrast to traditional Chapter 11 cases, no creditors’ committee is appointed in Sub-Chapter V cases, unless the court orders otherwise. Although a Sub-Chapter V debtor will have to pay the fees of a Sub-Chapter V trustee, such fees are typically a small fraction of the fees charged by committee counsel. The absence of a potential creditors’ committee in Sub-Chapter V cases is a big reason why a qualified debtor might elect to file a Sub-Chapter V petition rather than a traditional Chapter 11 petition.

3. The Disclosure Statement

In traditional Chapter 11 cases, a DIP is required to obtain court approval of a “disclosure statement,” before creditors are permitted to vote on a plan of reorganization. The purpose of a disclosure statement is to provide creditors with sufficient information to cast an informed vote for or against the plan. The preparation of a disclosure statement often requires the assistance of accountants and other professionals, like business and real estate appraisers and tax attorneys to prepare charts, financial projections, and a liquidation analysis, and to explain to creditors the tax consequences of the plan, among other minutiae. Except in the simplest of cases, disclosure statements and related exhibits can run hundreds of pages long and cost tens of thousands of dollars to prepare. Litigation regarding the adequacy of the disclosure statement can cost tens, even hundreds of thousands of dollars, in addition to the cost of preparing the disclosure statement itself. If there is a creditors’ committee, the DIP is paying two sets of attorneys who are often battling each other. It can take several months just to get a disclosure statement approved by the court.

In Sub-Chapter V, by contrast, no disclosure statement is required, potentially saving the DIP tens, if not hundreds of thousands, of dollars and months of time.

4. The Chapter 11 Plan and the Absolute Priority Rule

With some important exceptions, the goal in most Chapter 11 cases is for the DIP to confirm a plan of reorganization so that it can get on with business after having reduced and/or stretched out payment of its obligations to creditors. In all Chapter 11 cases, creditors are sorted into different “classes.” Once a disclosure statement is approved, most creditors are entitled to vote on the plan. If enough creditors vote in favor of the plan, the court will “confirm” the plan, provided that it meets certain criteria. For example, in a traditional Chapter 11 case, the court may not confirm a plan if any general unsecured creditors receive any payments before higher priority creditors are paid in full. Or the court will refuse to confirm a plan if the debtor’s owner(s) retain their equity, unless either all creditors vote in favor of the plan (something that rarely happens) or unless the owners make a “substantial contribution” to the funding of the plan. This is called the “Absolute Priority Rule.” The bankruptcy code does not say what “substantial contribution” means, but in practice, judges typically require the debtor’s owners to put up cash equal to 10%-15% of the total unsecured debt against the company if they want to retain their equity interest.

Before Sub-Chapter V, the Absolute Priority Rule was an insurmountable obstacle for many small business owners who could not afford to make a “substantial contribution” to their company’s plan. Sub-Chapter V does away with the Absolute Priority Rule, removing a major hurdle to the reorganization of many small businesses.

Rather than requiring individual business debtors or the owners of small businesses to either make a “substantial contribution” or pay all creditors in full to keep their worthless—on paper at least—interest in their companies, they need only show that the plain is “fair and equitable.”

As mushy a standard as “substantial contribution” is, the “fair and equitable” requirement is even more amorphous. In practice, however, it appears to require at least that a debtor pay creditors the liquidation value of their non-exempt assets and/or that an individual debtor pay at least 5 years’ worth of disposable income over that same period of time. In cases where the Sub-Chapter V debtor is an entity, a plan that is fair and equitable must prevent the company from over-paying insiders while the plan is being consummated, such that creditors receive a reasonable distribution on their claims. What’s “fair and reasonable” depends on the circumstances of each case. An experienced Southern California Chapter 11 bankruptcy attorney, especially a certified bankruptcy specialist, will be familiar with the predilections of the bankruptcy judges in the Central District of California and should be able to negotiate with lenders, trade creditors, judgment holders, taxing authorities, and other parties-in-interest to craft a confirmable plan in most cases.

5. UST Fees

In traditional Chapter 11 cases, a DIP must pay fees each quarter to the UST based on its quarterly disbursements. Such fees can approach $500,000, although they are typically much less. In Sub-Chapter V, by contrast, the DIP is not required to pay any UST fees.

So why doesn’t every troubled business file Sub-Chapter V, rather than a traditional Chapter 11?

Not every candidate for a traditional Chapter 11 bankruptcy will qualify for Sub-Chapter V. And most bankruptcy attorneys have never confirmed a Sub-Chapter V plan. Here are some reasons why Sub-Chapter V can be so complicated for individuals and even attorneys who don’t regularly practice in Chapter 11 cases:

• (a) To qualify for Sub-Chapter V, an individual or entity must be an entity or individual “engaged in commercial or business activities.” But what is a commercial or business activity for the purpose of Sub-Chapter V? Does an employee of a corporation or LLC qualify? What about an investor? What if an individual has personally guarantied her corporation’s lease and credit line, the company has ceased operating, but the individual sells $100 of collectibles each month on eBay? The answers to these questions require a case-specific analysis and may even depend on the district in which the case is filed or who the judge is in a particular case.
• (b) Even an individual or entity engaged in business may not qualify if the case involves “single asset real estate.” The bankruptcy code defines “single asset real estate to mean a case in which the debtor owns a parcel of a certain kind of real estate or a real estate “project” on which the debtor conducts no “substantial” business, other than operating the property and “activities incidental thereto.” What if the debtor owns a vacant building in foreclosure, but is trying to lease, sell or refinance it? Is he “operating” the property? What if the debtor also does consulting work? Still a single asset real estate case? Again, the answers are likely case specific and may depend on the judge.
• (c) Even if the debtor is engaged in commercial or business activities and is not a single asset real estate debtor, it may not qualify if it has more that $7.5 million in non-contingent, liquidated debt. But what if an individual has personally guarantied her corporation’s commercial lease with rent of $100,000 per month and there’s 15 years left on the lease? Is she over the debt limit? Is the corporation over the debt limit? The answer may depend on whether or not the lease is current or if a 3-day Notice to Quit has expired. If the case involves personally guarantied obligations, the potential debtor should consult counsel promptly, because an otherwise qualified debtor can very quickly lose the ability to file a Sub-Chapter V case if the court decides that the debt is no longer contingent. What if the potential debtor is a defendant to litigation and the jury has returned a verdict of $6 million against the defendant, but has yet to award punitive damages, which will almost certainly be at least $5 million. Is the debtor over the $7.5 million limit? Perhaps not today. But the answer may be different tomorrow. Here, too, qualified bankruptcy counsel should be consulted quickly, lest the potential Sub-Chapter V debtor lose eligibility once the debt is liquidated.

• (d) Even if debtor is engaged in a non-single asset business and has less than $7.5 million of non-contingent, unliquidated debt, she still may not qualify unless “at least 50 percent of her debts arose from its commercial or business activities.” This criterion continues to be litigated throughout the country. Does an individual’s tax obligations arise from “commercial or business activities”? What if the business was and remains engaged in multiple businesses, but the business that generated most of the debt is about to cease operating? Does eligibility depend on whether the highly indebted business is operating on the day the Chapter 11 petition is filed, even if it ceases to operate 3 days later? The answers to these questions are different answers in different parts of the country and may depend on other factors that are case or judge specific. Potential debtors and their non-bankruptcy professionals should consult an experienced bankruptcy specialist in the district where the debtor may file.

Conclusion

Chapter 11 can be prohibitively expensive. Even Sub-Chapter V cases are by no means “cheap” to prosecute successfully. However, for the right business owner, Sub-Chapter V cases can be extremely cost-effective by comparison to traditional Chapter 11 cases.

However, not every potential Chapter 11 debtor will qualify for Sub-Chapter V. Potential Sub-Chapter V debtors must be individuals or entities engaged in a non-single asset real estate business, have non-contingent, liquidated debts that total less than $7.5 million, and must have incurred more than half their debts in the course of their commercial or business activities. For those who do qualify and who would be well served by a Chapter 11 reorganization, Sub-Chapter V is often the best way forward.