We Need a Bankruptcy System for Small Businesses Without the Absolute Priority Rule: Two Alternatives

 

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A small business location (photo by Grant Swanson)

By Donald L. Swanson

During the entire existence of the Bankruptcy Code (enacted in 1978), Chapter 11 rules have been essentially the same for large and small businesses. General Motors, for example, is governed by the same Chapter 11 bankruptcy rules that govern every small Mom & Pop enterprise.

I’ve always thought this same-treatment to be an oddity, if not a bizarre fact. Similarities and differences between a multi-billion dollar business and a Mom & Pop enterprise are like similarities and differences between the sun and the moon. For example:

–both the sun and the moon are celestial bodies that exert a gravitational influence on and provide light to the earth; yet the differences between them are immense.

–both a multi-billion dollar enterprise and a Mom & Pop enterprise conduct business, employ people, and pay taxes; yet the differences between them are immense.

So, why do we require every Mom & Pop enterprise to be governed by the same Chapter 11 bankruptcy rules as General Motors? In particular, why would Mom & Pop enterprises be governed by the same absolute priority rule that applies to General Motors and other multi-billion dollar enterprises?

The answer is this: they shouldn’t!

Absolute Priority Rule

The absolute priority rule is all about the owners of a business. It provides this:

–to get a Chapter 11 plan confirmed, the owners of the business cannot retain their ownership interests (or anything else), unless unsecured creditors are being paid in full or agree to receive something less.

Human nature, being what it is, means that creditors will not agree to something less while owners retain their ownership interests (absent special or unusual circumstances).

Large Businesses v. Mom & Pop Enterprises

The absolute priority rule makes sense for a multi-billion dollar business. The owners of such businesses are, typically, thousands of passive investors who have no particular affinity for the business beyond the hope and expectation of receiving a good return on investment. Indeed, many owners are part of an investment fund and may not even be paying attention to where their money is invested. Many others will have no involvement in management of the business beyond voting, periodically, for or against a slate of proposed directors. For these investors, the reality of a Chapter 11 filing by their debtor means nothing more than a loss of investment.

Moreover, the elimination of these passive investors under a Chapter 11 plan will have no impact, whatsoever, on operations of the business. In General Motors, for example, the making of cars continued on, despite its bankruptcy filing and despite a change in owners.

In a Mom & Pop enterprise, however, owners and operators of the business are, typically, the same people: a small group of entrepreneurs. And many debts of the business are, often, guaranteed by this same group. These owners / operators / guarantors have committed their time, energy and resources to making the small businesses work. When financial difficulties arise for their businesses, these entrepreneurs dip into all available resources to keep the business going: they take money out of personal savings accounts, take a second mortgage on their house, get loans from relatives, and divert money from withholding taxes to meet payroll. All of these actions carry great personal risk.

In other words, without Mom and Pop, there is no Mom & Pop enterprise. So . . . why do we make Mom & Pop subject to the same absolute priority rule as General Motors?

The answer is this: we shouldn’t!

Another difference between multi-billion dollar businesses and Mom & Pop enterprises relates to the pre-bankruptcy effort.

General Motors, for example, spent months of planning and negotiating and preparing before finally filing its bankruptcy petition back in 2009. And so the time spent in bankruptcy before confirmation of its Chapter 11 plan is marked by efficient and effective action.

By the time owners of a small business begin looking at bankruptcy options, on the other hand, their business is already in mortal peril: liquid resources are nearly dried up, and they have nowhere else to turn when the bank starts sweeping cash out of their business account. Chapter 11 is the only available option for owners to regain control of their business and preserve its viability–at least for a while. So, the Mom & Pop bankruptcy filings tend to be more emergency-based, with little planning time or opportunity. And the bankruptcy filings tend to be more like “fire, ready, aim.”

Understandings on what can and cannot be accomplished in bankruptcy—and what the risks and perils might be for insiders—also tend to be dramatically different between those who provide day-to-day management of large and small businesses.

Managers of large businesses tend to be highly sophisticated, with access to advisors having high levels of expertise in bankruptcy issues. So, they typically go into a bankruptcy filing with a full understanding of its perils and of the opportunities for minimizing risks for themselves and other insiders.

Owners of Mom & Pop enterprises, on the other hand, often have an incomplete or skewed idea of what they might accomplish in a Chapter 11 filing.

–As to incomplete information, Mom & Pop owners, at bankruptcy filing, are often less-than-fully aware of the one-year reach-back on preference exposure and the four-year reach-back on fraudulent transfer claims. And many don’t fully understand what the absolute priority rule actually means.

–As to skewed information, they’ve heard that General Motors filed Chapter 11 and confirmed a plan of reorganization quickly; and they’ve heard that the General Motors bankruptcy plan jettisoned a bunch of unsecured debt, which allowed General Motors to continue operating after bankruptcy in a leaner-and-meaner mode.

“We want that deal,” is what small business owners are thinking.

What they don’t realize, however, is that ownership interests in General Motors were jettisoned under the plan of reorganization, along with unsecured debt. Although the General Motors business kept going after plan confirmation, the ownership class didn’t: owners lost their entire investments in General Motors.

That’s not, exactly, what small business owners have in mind when they are thinking of bankruptcy relief. They want, more than anything else, to keep their business alive and operating — and with the owners/operators remaining in control. Unfortunately, Chapter 11 won’t allow most of them to meet either their keep-it-alive or remain-in-control goals: and that’s because of the absolute priority rule.

Over the years, there have been adjustments in Chapter 11 to minimize costs for small businesses (e.g., by shortening time periods and eliminating the creditors committee). Costs for a small business are certainly a problem to be addressed in Chapter 11. But the real Chapter 11 problem for small businesses is the absolute priority rule. Every time one of the Chapter 11 cost cutting measures is adopted for small businesses, I want to say:

“Thanks for nothing. What small businesses need is an elimination of the absolute priority rule!!”

Eliminating the Absolute Priority Rule

Eliminating the absolute priority rule is exactly what happened in 1986 with the adoption of Chapter 12 for farmers. During the Farm Crisis days of the early 1980s, when prices of farm products, land and used equipment dropped dramatically and interest rates skyrocketed, many farmers filed Chapter 11 to forestall foreclosures. But, almost uniformly, the absolute priority rule prevented farmers from getting their plans of reorganization confirmed. The U.S. Supreme Court, when given the opportunity to limit the effect of the absolute priority rule, declined to do so. Here’s the Court’s expression of empathy for the plight of farmers, while retaining an unbending position on the absolute priority rule:

“Family farms hold a special place in our Nation’s history and folklore. Respondents and amici paint a grim picture of the problems facing farm families today, and present an eloquent appeal for action on their behalf. Yet relief from current farm woes cannot come from a misconstruction of the applicable bankruptcy laws, but rather, only from action by Congress.”

Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 209 (1988).

In reaction to the inflexibility of the absolute priority rule, Congress adopted Chapter 12 of the Bankruptcy Code.

Chapter 12 provides a system of debt relief and reorganization that’s similar to Chapter 13. For starters, it eliminates the absolute priority rule. A farmer can get a plan confirmed by satisfying two primary standards:

–paying, over time, the value of assets being retained; and

–committing five years of disposable income to creditors.

Chapter 12 even provides discharge relief for farmers from taxes arising from pre-petition sales of farm assets. Accordingly, Chapter 12 has been providing effective debt relief and reorganization for many farmers over many years. This has benefited both the Chapter 12 farmers and their local communities.

Here’s what small businesses need from the Bankruptcy Code: a bankruptcy system that removes the absolute priority rule and allows small businesses to actually reorganize. Here are a couple approaches for how this might happen:

First Approach: Broaden the Availability of Chapter 12 to All Small Agribusinesses

The availability of Chapter 12 could be broadened to include all small businesses in agricultural communities. Frankly, I often wonder why this hasn’t already happened. Our Chapter 12 experience is now more than three decades old. And that experience is positive.

Back in the years shortly after Chapter 12’s enactment, commentators note that that bankruptcy plans are being approved in Chapter 12. They see this, back then, as a dramatic departure from the no-confirmation experience in Chapter 11 farmer cases of prior years.  And they worry, back then, that such a change in power will have negative consequences on the agricultural community.

Rather than a negative, however, changes in Chapter 12 proved to be a boon for everyone involved.  This is because farmer liquidations in Chapter 11 were commonly at bottom-dollar-prices in which everyone turned up a loser.

Also, back in those days, commentators worried that the existence of Chapter 12 and its reorganization possibilities would raise borrowing costs for farmers. This worry has never materialized in reality. Instead, the reality, in retrospect, is that Chapter 12, (i) allowed farmers to stay in possession, (ii) allowed many plans to be confirmed, (iii) allowed a high percentage of plans to be completed, and (iv) limited the amount of upheaval and trauma in farming communities that characterized the Chapter 11 days.

Second Approach: Adopt ABI Commission Recommendations for Small and Medium-Size Businesses

The ABI Commission to Study the Reform of Chapter 11 offers numerous recommendations for small and medium-size businesses in Chapter 11. Two of these recommendations are new-and-creative and hold great promise.

One recommendation establishes a new office of an “estate neutral”: someone with financial and business expertise to assist the debtor in evaluating the business and how it might be reorganized. Here is the language of the Commission’s “estate neutral” recommendation:

“an estate neutral . . . has the authority to advise the debtor in possession on operational and financial matters, as well as the content and negotiation of its plan. . . . Any estate neutral should represent the interests of the estate and be paid by the estate.”

Another recommendation replaces the absolute priority rule with a system that converts unsecured debt to equity, with a four-year redemption deadline. Here is the debt-to-equity language from the Commission’s Recommendation:

“The prepetition unsecured creditors as a class receive 100 percent of a class of preferred stock . . . issued by the reorganized debtor on the effective date . . . with the following features: (i) pro rata voting rights, limited to voting only on the extraordinary transactions . . . ; and (ii) entitlement as a class to receive 85 percent of any economic distributions from the reorganized debtor.”

And here is the redemption language from the Commission’s Recommendation:

“creditors’ preferred interests mature on the fourth anniversary of the effective date, at which time the interests should convert into 85 percent of the common stock, or similar ownership interests, of the reorganized debtor, unless redeemed in cash on or before the maturity date for their full face amount.”

Conclusion

The Bankruptcy Code needs to be reformed to provide a reorganization opportunity for small businesses that eliminates the absolute priority rule. Each of the two alternatives mentioned above would fit this bill, and both need to be evaluated and pursued with all-due haste.

**  If you find this article of value, please feel free to share.  If you’d like to discuss, let me know.

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