Newly-Proposed Bankruptcy Legislation (“Small Business Reorganization Act”) Needs To Be Enacted ASAP

By: Donald L. Swanson

New bankruptcy legislation to help small businesses and entrepreneurs, titled the “Small Business Reorganization Act (SBRA),” is wending its way through the U.S. Senate.

This piece of legislation is long over-due and should be enacted with all due haste. Here are some reasons why.

Mom & Pop Businesses Have the Same Bankruptcy Rules as Conglomerates

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 Mom & Pop enterprises.

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; and
–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 Mom & Pop enterprises to be governed by the same Chapter 11 bankruptcy rules as General Motors?

The answer is this: we shouldn’t!

Absolute Priority Rule Eliminated for Small Businesses

One change in the new legislation is an elimination of the absolute priority rule for small businesses.  The absolute priority rule is all about the owners of a business. It provides:

–to get a Chapter 11 plan confirmed, 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, assures that creditors will not agree to something less while owners retain their ownership interests, absent special or unusual circumstances.

The absolute priority rule has, since enactment of the Bankruptcy Code, prevented many small businesses from obtaining effective bankruptcy relief under Chapter 11. This is a defect in our Bankruptcy Code. Fortunately, the absolute priority rule does not exist as a plan confirmation standard in Chapter 12 (farmer reorganization) or Chapter 13 (consumer reorganization) of the Bankruptcy Code. And it should not exist in Chapter 11 for small business reorganizations.

The new legislation adjusts plan confirmation standards for small business reorganizations toward Chapter 12 and Chapter 13 standards — and provides distance from rules governing multi-billion dollar conglomerates — by eliminating the absolute priority rule. This change is much-needed and long over-due. Here are some reasons why.

–Large Businesses

The absolute priority rule makes sense for multi-billion dollar businesses. 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 return on investment. Indeed, many owners are part of an investment fund and may not even know where their money is invested. Many others will have no involvement in management of the business beyond voting, periodically, on a slate of directors. For these passive investors, the reality of a Chapter 11 filing by their debtor means a loss of investment — nothing more.

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

–Mom & Pop Enterprises

In Mom & Pop enterprises, 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, efforts and resources to making the small businesses work. When financial difficulties arise, these entrepreneurs dip into personal resources to keep the business going: they work without a paycheck, 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!

Pre-Bankruptcy Preparations

Another difference between multi-billion dollar businesses and Mom & Pop enterprises, demonstrating the gulf of disparity between them, relates to pre-bankruptcy efforts.

–Pre-Bankruptcy Planning

General Motors, for example, spent months of planning and negotiating and preparing before filing its bankruptcy petition back in 2009. And so its time in bankruptcy before plan confirmation 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, Mom & Pop bankruptcy filings tend to be more emergency-based, with little planning time or opportunity. And the bankruptcy filings tend to be a “fire, ready, aim” effort.

–Levels of Understanding

Understandings on what can and cannot be accomplished in bankruptcy—and what the risks and perils and solutions might be for insiders—also tend to be dramatically different between those who provide day-to-day management of large businesses and of 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, for example, 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, for example, 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 discharged 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 the discharge of unsecured debt. Although the General Motors business kept going after plan confirmation, the ownership class didn’t: the 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.

Chapter 12 Example for 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, prices of farm products, land and used equipment dropped dramatically, interest rates skyrocketed, and 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 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. Due to elimination of the absolute priority rule, a farmer can get a plan confirmed by satisfying two primary standards:

• paying, over time, the value of non-exempt assets being retained; and
• committing several years of disposable income to creditors.

Our Chapter 12 experience is now more than three decades old. And the experience is positive: Chapter 12 has been providing effective debt relief and reorganization for farmers throughout that time. This has benefited both the Chapter 12 farmers and their local communities by, (i) allowing farmers to stay in possession of their farms, (ii) allowing many plans to be confirmed, (iii) allowing a high percentage of plans to be completed, and (iv) limiting the upheaval and trauma in farming communities that characterized the Farm Crisis days before Chapter 12.

The new small business bankruptcy legislation provides a similar reorganization possibility and benefits for small businesses, entrepreneurs and the communities they serve.

Conclusion

The Bankruptcy Code needs to be reformed to provide an effective reorganization opportunity for small businesses and entrepreneurs.

The newly-proposed legislation, titled the “Small Business Reorganization Act (SBRA),” would do just that.

Its enactment needs to be pursued and accomplished with all-due haste.

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