How to Save Your Business from Financial Distress: The Potency of Subchapter V of Chapter 11

[Editors’ Note: If you’re looking for ways to address your company’s financial distress, you have probably already come across many articles from a variety of non-attorneys offering to save your business. Examples include ‘friendly Article 9 sales” (also sometimes referred to as ‘Article 9 reorganizations’) and ABCs (“ABC”) stands for assignment for the benefit of creditors.” These options have their place, to be sure, but none is a panacea; each has its limitations, and each comes with its own unique execution risk. Traditional Chapter 11, on the other hand, has few limitations in terms of what it can help a struggling company accomplish. The problem with it is that it is simply too expensive for many companies. This, in fact, is the main reason that alternatives to chapter 11, such as those mentioned above, have exploded over the past two decades.¹ In this article, the authors explain in plain English what Subchapter V of Chapter 11 is and how it can be used to save a financially distressed business.]

Past is Prologue, What’s New is Old: Cramdown & the Absolute Priority Rule

Once upon a time, before the Bankruptcy Code replaced the Bankruptcy Act, there lived two distinct bankruptcy reorganization paths for businesses: Chapter X for public companies and Chapter XI for others. And it was even earlier when the Supreme Court articulated the earliest form of what it would later refer to as the ‘absolute priority rule,’ in 1868, by pronouncing “stockholders are not entitled to any share of the capital stock nor to any dividend of the profits until all the debts of the corporation are paid.”²

Fast-forward, however, and from 1952 until 1978, there was no absolute priority rule for Chapter XI debtors.³  It was the Bankruptcy Code of 1978, which put all debtors, regardless of size or public/private company status, into a single chapter 11 bucket. And in so doing, it codified for the first time the absolute priority rule for all debtors large and small.

Fast-forward some more: Congress created Subchapter V in 2018 because it came to realize that business bankruptcy cases should not be treated with a ‘one size fits all” approach. And, so, when it went into effect the following year, it eliminated many of the obstacles and costs smaller businesses faced while seeking to reorganize under traditional Chapter 11. – – albeit at the expense of unsecured creditors.⁴

Executive Summary: Why Subchapter V is Such An Effective Tool

• Creditors’ committees are the exception rather than the rule⁵
• Debtor has the exclusive right to file a plan⁶
• Disclosure statements are the exception rather than the rule⁷
• A plan may be crammed down without garnering even a single impaired consenting class’s vote in favor
• The absolute priority rule has been eliminated and thus, there is no longer a need for a new value contribution to retain equity.⁸ These improvements to chapter 11 (at least from the debtor’s perspective) should not be construed as suggesting Subchapter V is ‘easy.’ There are stringent substantive and procedural protections for holders of unsecured claims and, more generally, the protections that Subchapter V offers to all parties in interest are considerable.⁹

Each of these changes, except the last, is quite straightforward. The remainder of this article delves deeper into just that, the relaxed cramdown requirements of §1191(b), which supplant those of §1129(b).

Cramming Down a Traditional V Plan

A traditional chapter 11 plan (i.e., one proposed other than in Subchapter V) must meet the requirements set out in §1129(a) to be confirmed, with the notable exception that the requirement stated in §1129(a)(8) (that each class of claims or interests accept the Plan or is not impaired under the Plan) is excused if the plan proponent crams down the plan under §1129(b).¹⁰ “Cram down” is an expression used by bankruptcy practitioners to signify the confirmation of a plan notwithstanding the rejection of the plan by an impaired class of creditors; in other words, the bankruptcy court is said to “cram the plan down the throat of a dissenting class.”

Section 1129(b)(1) in turn, requires a traditional cram-down plan to not “discriminate unfairly” and to be “fair and equitable” as to each class of claims or interests that is impaired under, and has not accepted, the plan.

Section 1129(b)(2), in subsequent turn, defines “fair and equitable,” and it does so differently based on whether the class at issue is comprised of a secured claim, one comprised of unsecured claims, or one comprised of equity interests.¹¹ A plan is fair and equitable as to a class of unsecured claims if the plan provides that either (a) each holder of a claim in that class “will receive or retain on account of such claim property of a value, as of the effective date of the plan, equal to the allowed amount of such claim; or (b) no junior class will receive or retain anything under the plan on account of its claim.” “Anything under the plan” includes the owners retaining their equity interests in the debtor. This Is the Absolute Priority Rule.

Cramming down a Subchapter V Plan

Section 1129(a)(8) and 1129(a)(10) are Excused

The first confirmation game-changer of Subchapter V is that cram down does not merely eliminate the need for a plan to satisfy §1129(a)(8)’s requirement that all impaired classes accept the plan.¹² It also excuses the need to satisfy §1129(a)(10) that at least one impaired class of creditors accepted the plan. Dayenu! Arguably, the only practical reason to bother soliciting votes to accept or reject a Subchapter V plan (other than it being required under the Code) is the rare chance that the plan is accepted by all impaired classes of creditors and, therefore a consensual plan.

No Absolute Priority Rule

The second game-changer is the total displacement of the absolute priority rule in the case of unsecured claims by a projected disposable income requirement. To be clear, the surgery Congress did to the Code to create Subchapter V still requires (under §1191(b)), as to the holder of an impaired claim or interest who has not accepted the plan, that the plan not discriminate unfairly and be fair and equitable to such holder.

The difference is that the definition of “fair and equitable” in Subchapter V does not, like in traditional chapter 11, mean the plan contemplates paying holders of allowed claims in a senior class 100% or that holders of junior claims and interests will be paid nothing. Instead, in Subchapter V, §1191(c)(2) now provides that a plan is fair and equitable as to a class of unsecured creditors or to a class of interests if either the plan applies all of its “projected disposable income” over three to five years to payments under the plan or the value of the property to be distributed under the plan in that same timeframe is not less than the debtor’s projected disposable income.¹³

Projected Disposable Income

As discussed above, the Subchapter V ‘fair and equitable’ requirement requires a debtor to commit all its “projected disposable income” during the life of the plan to paying claims under the plan.¹⁴

Section 1191(d) tells us that in subchapter V, a debtor’s “disposable income” is “the income that is received by the debtor and that is not reasonably necessary to be expended” for the following specific purposes:

• Maintenance or support of the debtor or a debtor’s dependent;
• Domestic support obligations arising after the petition date of the subchapter V case; or
• Payment of expenditures necessary for the continuation, preservation, or operation of the business of the debtor.¹⁵

Of course, in the Subchapter V of a business, only this last element applies. And, while the case law on Subchapter V is generally developing rapidly,¹⁶ there is a vast and sparse desert when it comes to published case law guidance on what expenditures a court should consider to be “necessary for the continuation, preservation, or operation of the business of the debtor.”

So, What Will Courts Consider to be “expenditures necessary for the continuation, preservation, or operation of the business of the debtor?”

Believe us, we looked for it. And we’ll keep looking for it as we continue to represent Subchapter V debtors. But published decisions that address this issue simply have not yet been written. Sure, in the context of deciding other issues, courts have said things like:

Debtor’s net cash flow is comprised of revenue left over after all expenses and debt service payments are made. In other words, Debtor’s profit. As stated previously, the Plan implicitly provides that the net cash flows will be deposited into the Fund each month. If Debtor had done this, it would be allowed for payment of expenses “necessary for the continuation, preservation, or operation of the business” under § 1191(d)(2) which includes such expenditures as the replacement of the HVAC units and to make payments under the Plan when revenues fall short. However, because Debtor did not escrow its profits into the Fund and provided no explanation as to where this revenue went, Debtor has failed to comply with § 1191(c)(2)(A).

In re Samurai Martial Sports, 644 B.R. 667, 684 (Bankr. S.D.Tex. 2022).

Great, we now know that in one particular case concerning whether a confirmed plan could be modified because a broken A/C unit caused lots of customers to stay away from a workout club, and where that, in turn, caused the debtor to miss some plan payments, that that the Judge thought that replacing the A/C unit would have constituted an expense that was “necessary for the continuation, preservation, or operation of the business of the debtor.”

But does that help you, reader, draw any general rules to practice by on the question of what is in and what is out? Of course not. What about- – –

• The broken pool at the summer camp that has five other pools?
• The raises that employees want?
• The 401(k) contributions the debtor historically made for employees?
• The company holiday party?
• Business dinners?
• R&D?

The inquiry is always going to be extremely, if not entirely, fact specific. Case law will surely develop, but each situation will as surely be unique. But this begs the question of how much weight will be given to the debtor’s view on the factual question. In other words, the key legal issue in this context that courts will grapple with, it seems obvious to us, is the extent to which debtors will be afforded the business judgment rule standard (or something like it) in deciding what expenditures are necessary for the continuation, preservation, or operation of the business of the debtor.

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We think you’ll also like:

1. Subchapter V of Chapter 11: A User’s Guide
2. Dealing with Distress for Fun & Profit— Installment #18—How to Confirm a Chapter 11 Plan

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can watch at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. The Nuts & Bolts of a Chapter 11 Plan
2. Chapter 11 Potpourri]

©2023. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.

1. See Why Out-of-Court Restructurings Are on the Rise, DAILY BANKRUPTCY REVIEW, October 24, 2007, at 11. Why so expensive? A fundamental reason is, perhaps, the ‘one size fits all’ process under chapter 11 until, that is, the advent of Subchapter V of Chapter 11. Until Subchapter V went into effect in 2019, little distinction existed between the rules and case law governing a small business debtor case and a mega-business reorganization case involving multimillion-dollar companies. See generally Friedland, Bernstein, Kuney and Ayer, Chapter 11–101 The Nuts and Bolts of Chapter 11 Practice: A Primer, NACM Oregon Informational Brief, Issue 8.15 (May 2009). After all, the issues involved in a $1 billion+ chapter 11 are not identical to those involved in a $100 million or $10 million chapter 11.  And the issues that drive, say, a “SARE” (single asset real estate) chapter 11 are different from those involving operating companies. Staying with SARE debtors for a moment, specific amendments have been made to the Code for this very reason, but they can go only so far. Moreover, sometimes, the special needs of special types of debtors have resulted in changes to the Code that apply to all debtors. A good example of this is the accepting-class requirement of §1129(a)(10), which originated as a Congressional response. In re Pine Gate Assocs. Ltd., No. B75-4345A, 1976 WL359641, at 17 (N.D. Ga. Oct. 20, 1976); see also National Bankruptcy Review Commission Final Report, Bankruptcy: The Next 20 Years, Oct. 20, 1997, at 584, n.1474 (stating that § 1129(a)(10) was enacted in response to Pine Gate and its progeny). All of this is to say that traditional Chapter 11, while potent medicine, often kills the patient.
2. Chi., Rock Island & Pac. R.R. v. Howard, 74 U.S. 392, 409–10, 7 Wall. 392, 19 L.Ed. 117 (1868). The absolute priority rule was never codified under the Act. The closest Congress came was to amend the Bankruptcy Act to require a finding that a plan was “fair and equitable and does not discriminate unfairly in favor of any class of creditors or stockholders.” See Pub.L. No. 73–296, 48 Stat. 911, 919 (1934).
3. Congress expressly prohibited application of the absolute priority rule in the context of Chapter XI by its passage in 1952 of an amendment that explicitly prohibited a court from refusing to confirm a plan “solely because the interests of a debtor, or if the debtor is a corporation, the interest of its stockholders or members will be preserved under the arrangement.” See Pub.L. 456, 66 Stat. 420, 433 (1952). In re Maharaj, 681 F.3d 558, 561 (Fourth Cir. 2012) (footnotes omitted) includes a salient and concise discussion: “The legislative history to the 1952 amendments to the Act reflects that Congress intended an express repeal of the judicially created absolute priority rule in the context of Chapter XI (which was designed for small, privately held businesses). ‘[T]he fair and equitable rule … cannot realistically be applied…. Were it so applied, no individual debtor, [and] no corporate debtor where the stock ownership is substantially identical with management could effectuate an arrangement except by payment of the claims of all creditors in full.’ H.R.Rep. No. 82–2320 (1952) reprinted in 1952 U.S.C.C.A.N. 1960, 1982.” And, so, contrary to what some might believe, the rights taken away from general unsecured creditors (“GUCs”) by Subchapter V did not date from time immemorial. Rather, Subchapter V merely marks a return to what once was.
4. See The SBRA and Its Impact on Trade Creditors (National Association of Credit Managers, August 2020) (last visited 3/20/23).
5. Section 1181(b) provides that, excepting §1102(a)(3), neither §1102 nor §1103 applies in Subchapter V unless the court orders otherwise. Section 1102(a)(3) expressly provides that “[u]nless the court for cause orders otherwise,” a committee may not be appointed in a small business case or a subchapter V case.
6. This benefit is constrained by the requirement that under §1189(b), a plan must be filed within 90 days of the Petition Date. This compares unfavorably to the 300-day deadline under §1121 in traditional chapter 11. However, (a) “the court may extend the period if the need for the extension is attributable to circumstances for which the debtor should not be held accountable;” and (b) in contrast to traditional chapter 11, there is no stated upper limit after which the court loses the authority to extend the period. See, e.g. In re HBL SNF, LLC, 635 B.R. 725, 730-31 (Bankr. S.D.N.Y. 2022) (granting a motion to extend the debtor’s plan filing deadline); In In re Baker, 625 B.R. 27, 36 (Bankr. S. D. Tex. 2020); but see In re Excellence 2000, Inc., 636 B.R. 475 (Bankr. S.D. Tex 2022) (denying an emergency motion for an extension of §1189(b)’s 90-day deadline to file a plan where the motion was filed one day after the expiration of the 90-day deadline and the circumstances for the extension raised by debtor were within its control); In re Majestic Gardens Condominium C Association, Inc., 637 B.R. 755 (Bankr. S.D. Fla 2022). Moreover, §1112 is applicable in Subchapter V, and it provides a path to conversion or dismissal under subsection (b)(4)(J) for failing to confirm a plan within the time fixed for doing so.
7. A subchapter V debtor is not required to file a separate disclosure statement unless the court orders otherwise for cause, in which case, the disclosure statement requirements for small business cases under §1125(f) apply.
8. Subchapter V confers other benefits, such as requiring no United States Trustee quarterly fees, which do not change the balance of power between debtor and unsecured creditor. These are beyond the scope of this article, though one other is worth mentioning: in traditional chapter 11, a plan must under §1129(a)(9)(A) pay administrative and gap claims in full on the plan’s effective date unless the claim holder agrees otherwise. Section 1191(e), however, provides that a plan crammed down in Subchapter V may provide for payments of these claims over time. While this provision may at first glance seem innocuous to unsecured trade creditors, it’s not. Vendors who shipped goods received by the debtor in the ordinary course of business within 20 days before the filing of the petition date as well post-petition vendors, are harmed, albeit not in their capacities as mere general unsecured creditors. See generally Subchapter V of Chapter 11: A User’s Guide, last visited 2/23/23; Strat. Alt. Dis. Bus. § 5:16 (Thomson Reuters, 2023).
9. In the confirmation context, for example, if a subchapter V debtor crams down its plan, the debtor will not receive a discharge until all plan payments are made, and there comes into play a more expansive definition of ‘property of the estate” under §1186.  More generally, §1191(c) requires that, for a Subchapter V plan to be fair and equitable, the debtor must show it will (or a reasonable likelihood that it will) be able to make all payments called for under the plan and that “the plan provides appropriate remedies, which may include the liquidation of nonexempt assets, to protect the holders of claims or interests in the event that the payments are not made.”
10. A detailed discussion of confirmation in traditional chapter 11 is beyond the scope of this chapter but for a couple of plain English summaries see Dealing with Distress for Fun and Profit – Installment 7 – Plan Confirmation
11. The requirements to cramdown a secured creditor are identical in Subchapter V as in traditional chapter 11; the right of a secured creditor to make an §1111(b) election also remains the same.
12. The removal of this requirement eliminates a role for unsecured creditors to otherwise play when secured lender is pitted against debtor. Subchapter V also excuses §1129(a)(15), which pertains only to individual chapter 11 debtors. That is beyond the scope of this article.
13. This standard was modeled on §1225(b)(1)(C), which was added to chapter 12 in the 2005 BAPCPA amendments to provide family farmers with more flexibility in the timing of their plan payments to account for the cyclical nature of farming.
14. §1191(c)(2)(a). The “projected disposable income” test is not a new concept in bankruptcy, but its incorporation into subchapter V (and specifically its application to non-individual chapter 11 debtors) is. In chapters 12 and 13 of the Bankruptcy Code, the term “disposable income” is a defined term. See §§1225(b)(2), 1325(b)(2). And in individual chapter 11 cases, §1129(a)(15) incorporates the definition from chapter 13.
15. This definition is nearly identical to the chapter 12 and 13 definitions, with the most notable difference being that the chapter 13 definition permits debtors to deduct charitable contributions from their disposable income.
16. See, e.g. In In re RS Air, LLC, 638 B.R. 403, 407, 415 (B.A.P. 9th Cir. 2022) (affirming confirmation despite that the debtor would have no disposable income in the five years following plan confirmation, and whose primary financial benefit was to provide flow-through tax deductions, at least in part because the plan was funded by the debtor’s sole member and manager), In In re Double H Transportation LLC, 2022 WL 1916686 at *5-6 (Bankr. W.D. Tex. May 16, 2022) (denying confirmation where debtor “failed to introduce credible evidence supporting its projected disposable income”); In In re Sizzler USA Acquisition, Inc., et al., Case No. 20-30748 (Bankr. C.D. Cal.) (court confirmed over subchapter V trustee’s objection that plan did not commit debtor’s “actual” disposable income, if higher than the debtor’s projections.