(Can the Commission’s SME proposal better-adapt Chapter 11 for Main Street?)
(Yes, Bark Marketing needs to update for the upcoming season. Go Dawgs!)
This is the final post in Plan Proponent’s series on the plan confirmation-related recommendations in the ABI Commission Report. We wrapped-up our coverage of the Exiting the Case piece in our last post. In this (long overdue) “bonus” post, we’ll focus on the Commission’s confirmation-related recommendations in Section VII of the Report dealing with Small and Medium-Sized Enterprise (SME) Cases.
As Prof. Michelle Harner, the Reporter for the ABI Commission Report, pointed out in a Credit Slips post back in January, even though “most of the media and caselaw coverage discusses only the megacases” (i.e., 2 to 3% of all Chapter 11 debtors) “approximately 90% of all chapter 11 debtors have less than $10 million in assets or liabilities, less than $10 million in annual revenues, and 50 or fewer employees.” Additionally, Prof. Harner points to an empirical survey (ABI log-in required) conducted by Professor Dalié Jiménez and relied on by the Commission where “over half of the respondents disagreed with the statement that ‘[t]he Code provides sufficient tools for small and midsized debtors.’”
On the one hand, the Commission recognizes that concerns about small companies in bankruptcy are not new. After all, Congress added the small business provisions with the 1994 and 2005 amendments. Under those provisions, a “small business” debtor (very generally, a debtor with total debts that do not exceed $2,490,925) can “fast track” its Chapter 11 case. Particularly relevant to this blog, under Section 1121(e), small business debtors (i) have the exclusive right to file a plan during the first 180 days (as opposed to 120 days for other debtors); (ii) can extend the 180 day period if they demonstrate “by a preponderance of the evidence that it is more likely than not that the court will confirm a plan within a reasonable period of time” and they obtain the extension order before the existing deadline expires; and (iii) must file a plan (and disclosure statement, if required) no later than 300 days after the petition date.
Under Section 1125(f), the court may (i) determine that a separate disclosure statement is not necessary; (ii) approve a disclosure statement submitted on standard forms; (iii) conditionally approve a disclosure statement subject to final approval; and (iv) combine the hearing on the disclosure statement with the hearing on plan confirmation. And under Section 1129(e), a small business plan must be confirmed within 45 days after the plan is filed unless the court orders otherwise.
On the other hand, the Commission’s evaluation of those provisions suggested that the fast track approach can be “challenging and counterproductive” for small business debtors and is still challenging even after the 2005 amendments. To be sure, the 2005 amendments were a response to the criticism that small business debtors benefited from the initial delay and protection that comes with Chapter 11, but were merely prolonging their “imminent demise” in Chapter 11. Additionally, witnesses and commentators suggested to the Commission that small and medium-market debtors are relying on state and federal insolvency remedies more and more (e.g., receiverships, assignments for the benefit of creditors, etc.)–remedies that the Commission views as “subpar.” As the Commission points out, the general testimony was that, other than facilitating 363 sales and liquidations, Chapter 11 is “not working for small and middle-market debtors.”
Therefore, with the above statistics and considerations in mind, the Commission set out to make Chapter 11 work for small and medium-sized debtors by doing 3 things: “(i) simplifying the process; (ii) reducing costs and barriers; and (iii) providing tools to facilitate effective reorganizations for viable companies.”
Definition of an SME
The reasoning behind the Commission’s identification of the cut-off for qualifying as a “small or medium-sized enterprise” (SME) is beyond the scope of this post, but spelled-out in the Report. Generally though, an SME would be a “business debtor” who is (i) not public and (2) has less than $10 million in assets or liabilities, subject to the following:
- The SME proposal excludes individual debtors;
- An SME’s jointly-administered debtor affiliates must also satisfy the “not public” test;
- The assets/liabilities test is a consolidated test that includes debtor and non-debtor affiliates;
- The debtor must file a good faith balance sheet as of the petition date;
- The debtor’s SME designation is subject to objection from the court, the UST, or parties-in-interest;
- Non-public business debtors make seek SME status if (i) they file a timely motion; (ii) they have between $10 million and $50 million in assets or liabilities; and (iii) the court makes an evidentiary finding that SME status would be in the best interests of the estate for that debtor;
- Debtors that are “single asset real estate debtors” can’t be an SME; and
- The existing small business debtor provisions would be deleted from the Code.
The Commission believes that its SME definition would capture 85-90% of Chapter 11 filings.
Plan Filing Timeline
Focusing on the need to avoid prolonging cases unnecessarily while also avoiding artificial deadlines, the Commission recommends that:
- The 300 day filing and 45 day confirmation deadlines be deleted;
- Instead, SMEs should file a plan filing/solicitation timeline within 60 days after the petition date;
- Relying on that filing and Section 105(d)(2)(B), the court should enter a timeline order; and
- SME should be subject to, and court’s timeline order should be consistent with, the Section 1121.
[Note: The Commission doesn’t explicitly state that the 300/45 day rules go away, but it does recommend deleting all of the small business case provisions from the Code.]
Plan Content and Confirmation
The Commission acknowledges that there are different opinions about why Chapter 11 is difficult for small debtors. Some complain about the deadlines. Others suggest that the plan process and confirmation standards are almost impossible for small business debtors to satisfy. Still, others submit that reorganizing small debtors is just not feasible, generally.
In response, the Commission recommends the following:
- SME plans should provide for payment of all admin and priority claims per Section 1129(a)(9);
- Bifurcation of undersecured claims into secured claims and unsecured deficiencies consistent with Section 506;
- Section 1111(b) elections (and related confirmation provisions, e.g. Section 1129(a)(7)(B)) won’t apply to SMEs;
- Secured creditor distributions would continue to be governed by consent or by Section 1129(b)(2)(A);
- Unsecured creditor distributions are trickier. See below.
An SME plan would have up to 3 options for paying unsecureds.
First, unsecured claims could be paid as provided in the plan as long as each class of unsecured creditors consents. Second, unsecured claims could be paid via Section 1129(b)(2)(B) (i.e., cramdown) subject to the Commission’s “New Value Corollary” recommendation.
Finally, if all else fails, unsecured claims could be paid via an “SME Equity Retention Plan.” Basically, an Equity Retention Plan (ERP) is a device that would permit pre-petition equity interest holders to retain their ownership interests in the debtor even if the plan fails to satisfy the absolute priority rule. An ERP must:
- Require the equity interests to remain involved in the debtor’s operations at a level comparable to their pre-petition involvement.
- Provide that unsecured creditors receive the debtor’s excess cash flows for the first 3 full years following the plan effective date.
- Include (as a part of the disclosure statement) a budget that (i) summarizes how the excess cash flow calculation would be made and (ii) forecasts excess cash flow over the 3 years.
- Provide unsecured creditors with 100% of a class of preferred stock (or the like) whereby they (i) have pro rata voting rights for certain extraordinary transactions (only) and (ii) are entitled to 85% of the reorganized debtor’s distributions when the preferred interests mature in the 4th year.
- Extraordinary transactions: (i) anything related to changes in insider compensation, dividends, and the like; (ii) a sale of all or substantially all of the debtor’s assets, a dissolution, or a merger; or (iii) any organizational document changes that would change the rights of the preferred interests.
- Therefore, equity gets 100% of the common stock (subject to the extraordinary transaction voting rights of the preferred), but, in the 4th year, the preferred holders see their interests mature into an 85% common stock interest unless the debtor redeems them out in cash before maturity.
- The redemption price would equal the face amount of the unsecured creditor’s unsecured claim (less payments received under the plan prior to redemption).
Most of our cases, even on a consolidated basis, would fall within the SME guidelines. And as much as I’d like to report that we cramdown on the merits on a routine basis, I can only think of 1 case in the last 5 years that I crammed-down over the objection of a creditor. (The result was, if I do say so myself, an excellent opinion on Till from Judge Drake). If they’re reading, then perhaps my colleagues will correct me with additional examples. However, even they would agree that most good Chapter 11 cases, especially those that would be in the SME range, are hard-fought battles that settle at the 11th hour. The reason: It’s extremely difficult under the current Bankruptcy Code for an SME-sized debtor to cramdown.
A major contributor–if not THE contributor–to that difficulty is the absolute priority rule and its tendency to alienate equity. Therefore, we really like the ERP option. First, we even employed a version of an ERP in an ultimately-consensual (non-SME-sized) case that we had last year. Second, the ERP would give our mostly-closely-held clients a confirmation recipe that wouldn’t require consent, as long they’re confident they’d be able to perform their way out of an unsecured creditor takeover of the company within 3 years.
Unfortunately, though, we like the SME proposal so much that we’re also pretty sure that it will remain just that–a proposal. It would just be too much of a boon for debtors to go very far. And on that note, we conclude our 7 months of coverage of the ABI Commission Report!