Creditors Beware of Subchapter V Filings

At some point in nearly every trade creditor's career, they will be faced with a customer who files for bankruptcy. The steps taken to collect cash from a customer during bankruptcy will depend on how the customer files. Subchapter V is a newer modification of Chapter 11 for small businesses, but it places a larger burden on creditors to collect debt.

"The intent with Subchapter V is to streamline the process, and make it more efficient and less expensive for the debtor," Jason Torf, Esq., creditors' rights attorney and partner at Tucker Ellis LLP (Chicago) said during Subchapter V of the Bankruptcy Code: Its Impact on Trade Creditors. "But at the same time, it strips away certain elements of a traditional Chapter 11 that are beneficial to creditors."

Credit professionals may be sitting on a ticking time bomb without even knowing it. In fact, most (40%) creditors do not know what percent of their portfolio is made up of customers who qualify for Subchapter V bankruptcy, according to a recent eNews poll—and the 31% who do know the answer say 10% or more of their portfolio qualify for Subchapter V.

Creditors must be aware of how many of their customers could file using this subchapter because it makes it much more difficult to collect debt. You might even consider placing eligible customers in a higher risk category "because there will be a lot more factors working against the creditor if the customer files," Torf explained. "There is an additional layer of risk with Subchapter V that does not exist in the traditional Chapter 11 route, and debt recovery is not as successful."

Is Your Customer Eligible?

Subchapter V went into effect in February 2020, which means its third anniversary is coming up in 2023. Only small-business debtors whose total debts do not exceed $7.5 million can file for Subchapter V. The initial debt threshold was roughly $2.75 million, but the CARES Act increased that limit for another two years—and the expectation is that the $7.5 million threshold will become permanent.

But just because a customer files for Subchapter V does not mean they are actually eligible. The first step to protecting yourself is checking to make sure the customer actually qualifies. "There are so many more benefits to a creditor in a traditional Chapter 11 than a Subchapter V so don't just accept that because the debtor filed for Subchapter V, that they actually qualify," Torf explained. "Do your research to see if they are actually eligible because they might be trying to take advantage of the benefits that come with the subchapter."

The state in which a customer files also can impact eligibility, for example, in re Offer Space, LLC, No. 20-27480, 2021 WL 1582625 (Bankr. D. Utah April 22, 2021), the court ruled that Subchapter V does not require an operating business in order to be eligible as long as the debtor is engaged in "business activities." However, a court in Pennsylvania ruled a debtor ineligible under similar circumstances. "The lesson from this is if you have a customer who files for Subchapter V bankruptcy, take a close look at where they filed and what the court in that state has determined," Torf said.

Since the first case was filed in the Middle District of Tennessee on Feb. 19, 2020, a total of 1,643 bankruptcies were filed pursuant to Subchapter V or converted to a case under Subchapter V filed within its first year. The most Subchapter V cases filed during its first year were in the Middle District of Florida with more than 140 cases. Districts within Florida, California and Texas rounded out the top five, per Bloomberg Law.

"In the three years that Subchapter V has been around, there have been successful cases where the debtor was able to reorganize and stay in businesses," Torf said. "And there have been cases where creditors have been paid in full or paid a percentage of what was owed. But the favor in these cases typically lies with the debtor."

Subchapter V Traps

In a Subchapter V case, a creditors' committee is not automatically appointed, which "strips unsecured creditors from having a seat at the table in the same manner as in a traditional Chapter 11," Torf explained. "This allows the debtor to confirm a plan that is not in any benefit of the creditors and that might not have been confirmed under a Chapter 11 because the creditors' committee would speak up and object."

Subchapter V is a much quicker process than Chapter 11. "Bankruptcy deadlines are always short and easy to miss, but Subchapter V deadlines can be even shorter," said Lynnette Warman, Esq., partner at Culhane Meadows PLLC (Dallas, TX). "If you see that a case is under Subchapter V, don't wait. If you have a big enough claim, hire an attorney right away and if you're going to file a proof of claim, get that on file right away."

Another difference about Subchapter V that is not in favor of the creditor is a lack of the absolute priority rule. Under Chapter 11, creditors have to get paid according to priority, with equity last in line. But under Subchapter V, existing owners can retain ownership of the business even without paying unsecured creditors in full—as long as the debtor pays those creditors all "projected disposable income" over a three-to-five-year period.

Torf has seen a Subchapter V case where the debtor's proposed plan showed substantial payments in terms of bonuses and compensation to its insiders—equaling more than what they were paying unsecured creditors. It is a way for the debtor to artificially decrease disposable income. "They've utilized the Subchapter V process to their benefit by shifting money from creditors to insiders," he said. "We think that's an unfair use of Subchapter V, and we want to see a plan that takes out some of those unnecessary expense items and shifts money to unsecured creditors."

Subchapter V can "incentivize" debtors to put forth projections in its plan that minimize its disposable income so they can pay the least amount possible to creditors, and creditors do not have a chance to vote against that plan. If the debtor exceeds its income projection, the debtor gets to keep that money.

What Are Your Options?

Even though there is no creditors' committee in a Subchapter V, creditors can still ban together and hire counsel to form an ad-hoc committee. Members of that group can split the cost of counsel. "A creditors' committee might be more aggressive, or might take actions that a Subchapter V trustee would otherwise take," Torf said. "For instance, an investigation of transfers or maybe alter ego companies that management might be running."

Creditors still have some of the same general rights that they have under a traditional Chapter 11, such as secured and unsecured claims, reclamations, 503(b)(9) claims, the right to object to a plan and the option to not sell to a debtor post-bankruptcy. But creditors should also be aware that Subchapter V cases are more likely to fall in favor of the debtor. "The standards are relaxed compared to a standard Chapter 11, but I think there's a bit of bias in favor of the debtor, both in the code provisions and in the mindsets of judges," Warman said.

-Kendall Payton, editorial associate

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Monday, 27 May 2024

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