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Two Useful Alternatives for COVID-19 Triggered Business Insolvencies 

by Kenneth Cannon, Thomas Taylor

Published: July, 2020

Submission: July, 2020

 



The COVID-19 pandemic has triggered and will continue to trigger a “tidal wave” of business bankruptcies involving businesses both large and small.  Certain commentators have described the anticipated “tidal wave” of business bankruptcies as a “bankruptcy tsunami.”  In the three-month period between March 1, 2020 and May 31, 2020, a total of 1,812 Chapter 11 bankruptcies were filed in the U.S., representing a 31% year-over-year increase.  The bankruptcy filings of Hertz, J. Crew and 24 Hour Fitness are but some of the more highly-publicized bankruptcy filings recently made by large, well-known companies.  The New York Times estimates that the number COVID-19 triggered bankruptcies involving small to medium size businesses could exceed the record number of filings set the year after the 2008 economic crisis and the resulting “Great Recession.”  Many small and medium size businesses are anticipated to liquidate over the next several months after they exhaust their federal and state pandemic-relief/stimulus money, draw down and max out their lines of credit, and layoff and furlough workers.


Financially-distressed businesses have several options, including Chapter 11 bankruptcy (reorganization), Chapter 7 bankruptcy (liquidation), foreclosure and sale of assets under Article 9 of the Uniform Commercial Code (UCC), an out-of-court workout, and an Assignment for the Benefit of Creditors.  However, certain of those options are simply not realistic alternatives for many small and medium size businesses because of the cost and time involved, among other reasons.  For instance, a Chapter 11 reorganization can cost hundreds of thousands of dollars and take several months to a year (or more) for a company to restructure, and a Chapter 7 liquidation can cost tens of thousands of dollars and easily take months  to complete  and results in no discharge (only individuals receive a discharge in Chapter 7).


This article addresses two relatively-inexpensive possible alternatives for companies facing COVID-19 triggered insolvency—an Assignment for the Benefit of Creditors and a small business reorganization  filing under recently-adopted Subchapter V of Chapter 11 of the U.S. Bankruptcy Code.  Assignments for the Benefit of Creditors and small business reorganizations under new Subchapter V are two areas of the law in which bankruptcy and M&A lawyers find that their practices overlap


ASSIGNMENTS FOR THE BENEFIT OF CREDITORS


An Assignment for the Benefit of Creditors (an “ABC”) is a state law alternative to a federal bankruptcy filing.  An ABC is a tool whereby a debtor assigns its assets to an independent, third party assignee chosen by the debtor, sometimes in cooperation with a secured creditor, who will then sell those assets in an orderly, controlled manner with minimal court supervision and involvement, and without the delays and costs associated with a bankruptcy filing.  An ABC is a voluntary, state law alternative to a federal bankruptcy liquidation, with few formalities and generally minimal court proceedings and filings.  ABCs are a business liquidation device governed by state statue. ABC statutes have been adopted in virtually every state in the U.S., including Utah (the Utah Assignment for Benefit of Creditors statute is codified at Utah Code Section 6-1-1 (the “Utah ABC Act”)).  While ABC statutes vary from state to state, they all generally operate in a similar manner and require a similar process.  An ABC only makes sense for an insolvent company if it has significant assets to liquidate.


The ABC Process.  Under the Utah ABC Act, an ABC is commenced by the insolvent debtor, called the “assignor,” executing an assignment of its assets and assigning them to an assignee, in trust, for the benefit of the assignor’s creditors.  The ABC trust is legally distinct from the pre-assignment debtor.  The assignment transfers legal and equitable title to the debtor’s assets, as well as custody and control over those assets, to the assignee.  Because an ABC involves the sale of all or substantially all of the debtor’s assets, both board and shareholder/member approval generally must be obtained.


The Utah ABC Act requires that the assignment be in writing and set forth certain specified information and be recorded with the County Recorder’s office in the county where the debtor’s assets are located.  The assignment must include an inventory of the debtor’s assets and an indication of their location.  Once executed, the assignment is irrevocable and assigns title to the debtor’s assets, and all of debtor’s rights, titles and interests in its assets, to the assignee.  Upon recording with the County Recorder’s office, the assignment must then be filed with the District Court in which the debtor’s assets are located, and the District Court will supervise and oversee the ABC, although the court’s involvement is generally very limited.  The Utah ABC Act requires that the assignee notify all creditors of the ABC and sets forth certain priorities for claims related to certain debts, including unpaid taxes, for example.  The assignee will act in a fiduciary capacity for the creditors’ benefit and assemble and sell the debtor’s assets, wind down the assignor’s business in an orderly manner, and distribute the sale proceeds to the assignor’s creditors on a pro rata basis.


Benefits.  Among the benefits of ABC are the following:


  • Expediency—Generally, an ABC can be completed in several weeks, not months as is often the case with a federal bankruptcy filing
  • Cost Effective—An ABC avoids most of the costs and expenses associated with a federal bankruptcy filing
  • Maximization of Cash Distributions to Creditors—Because ABC’s do not involve such things as creditors’ committees, reorganization plan confirmation hearings, automatic stay disputes, or the numerous court hearings involved in a bankruptcy proceeding, the amount of cash distributable to creditors will be maximized
  • Efficiency—Because the District Court’s involvement is generally minimal, an ABC is much more efficient and less time consuming that a bankruptcy proceeding
  • Flexibility—An ABC affords the debtor much more flexibility than a traditional bankruptcy filing under the U.S. Bankruptcy Code and ability to know generally the outcome of the ABC process in advance
  • Ability to Select Assignee—A major advantage of an ABC is the debtor’s ability to select the assignee, with its creditors not being entitled to approve of or vote on the assignee
  • Privacy—Because an ABC has minimal court involvement, they are not very public and are discrete, thereby avoiding the embarrassment and unwanted publicity often associated with bankruptcies
  • Reputation Protection—ABC are often characterized as being an acquisition of the business or its assets, which avoids the negative connotations associated with a bankruptcy filing, thus protecting the goodwill and reputation of the debtor’s management personnel and investors
  • “Graceful” Business Exit—An ABC allows the debtor’s owners and management personnel to “gracefully” wind down the business and exit in a private proceeding

Drawbacks.  The drawbacks of ABCs include:


  • Lack of Certain Bankruptcy Protective Provisions—ABC’s do not provide the debtor certain protective provisions afforded by a bankruptcy filing, such as the ability to enforce executory contracts or protect against a counterparty to a contract terminating the contract
  • No Discharge Possible—Unlike certain Chapter 11 reorganizations, an ABC does not result in a discharge of debt, and, therefore, they are not appropriate for an individual debtor
  • No Ability to Rehabilitate or Restructure—An ABC cannot be used to financially rehabilitate or restructure a debtor company, unlike with a Chapter 11 bankruptcy
  • No Automatic Stay—Because ABC’s do not provide for an automatic stay, as is the case with a federal bankruptcy filing, creditors can continue to pursue the debtor, although in practice they generally don’t do so because, after the asset assignment, the debtor no longer has any assets
  • Limited Jurisdictional Reach and Risk of Non-Recognition by Other States—Because ABC statutes are creatures of state law and vary from state to state, there is always a risk that other states may not recognize or honor an ABC undertaken pursuant to another state’s ABC statute

SUBCHAPTER V OF CHAPTER 11 -- SMALL BUSINESS REORGANIZATION


New Subchapter V of Chapter 11 of the U.S. Bankruptcy Code, which is known as the Small Business Reorganization Act, became effective on February 19, 2020. It is intended to make available to small businesses a less expensive, shorter, and more effective alternative for restructuring a small businesses than is available under a traditional Chapter 11 case.


Reorganization under Chapter 11 of the Bankruptcy Code has become an important tool for restructuring and/or selling businesses in the United States over the past 40 years.  Most people remember the Chapter 11 reorganizations of such major U.S. companies as General Motors and Chrysler in the automotive industry, of most of the major airlines in the country, and of numerous other companies.  In Utah, Geneva Steel went through Chapter 11 twice, and Utah companies such as Flying J have also reorganized under Chapter 11 (although Flying J and some other large companies filed in Delaware).


Since at least 1994, Congress has been attempting to fashion a less-expensive and faster reorganization process for small to medium-sized businesses.  In the past, provisions governing “small business cases” have not been very workable or effective.  The Small Business Reorganization Act is a more ambitious attempt at giving smaller businesses an effective restructuring alternative under the Bankruptcy Code that applies most of Chapter 11, but modifies some of the most challenging provisions of Chapter 11.  Both business entities, such as corporations, limited liability companies and partnerships, as well as individuals who own a small business, are eligible to file under Subchapter V.


A substantial problem for small to medium-sized businesses in Chapter 11 cases is the cost.  Chapter 11 cases are lawyer and other professional intensive.  Creditors’ committees are often appointed in Chapter 11 cases and the “debtor” company, referred to as the “debtor-in-possession” (“DIP”) is required to pay the professional expenses of committees.  The plan confirmation process is expensive because the DIP must prepare and obtain bankruptcy court approval for a disclosure statement providing background and information regarding the DIP, its history and the proposed plan of reorganization.  A Chapter 11 case may go on for many months or even years.  Creditors may file competing plans of reorganization if the DIP does not promptly file a plan.  All of these provisions are eliminated or modified by new Subchapter V.


To be eligible to file a small business case under Subchapter V, the debtor must be engaged in commercial or business activity (other than owning single asset real estate) and must have less than $2,725,625 in non-insider, noncontingent, liquidated secured and unsecured debts.  At least 50% of the debt must have arisen from commercial or business activities of the debtor.  For a period of one year after the effective date of the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act), the debt limit to file a Subchapter V case has been increased to $7,500,000 and that increase may be extended further by Congress.  Thus, during a potentially short window, the debt limit of Subchapter V is almost tripled.  Chapter 11 cases meeting the requirements are not automatically treated as Subchapter V cases and the debtor must elect quickly to have its Chapter 11 case treated as a Subchapter V case or it will be treated as a regular Chapter 11 case.


A small business reorganization under Subchapter V of Chapter 11 is more streamlined, intended to be substantially less expensive, and includes provisions more favorable to a debtor (the debtor in these cases is also called a “debtor-in-possession,” even though a standing trustee is appointed to oversee all small business cases under Subchapter V).  In a case under Subchapter V, no creditors’ committee is appointed unless ordered by the court, no court-approved disclosure statement is required, and the plan of reorganization is simpler and may be proposed only by the DIP, thereby removing the possibility of a creditor filing a competing plan.  The timeline for a Subchapter V reorganization is much shorter than a typical Chapter 11 case, requiring the debtor to move its case along very quickly.  The debtor must file a plan of reorganization within 90 days after filing its petition.  Rather than prepare a separate disclosure statement, the small business debtor must include a brief history of its business operations, a liquidation analysis, and projections with respect to the debtor’s future operations to show its ability to make payments under the plan.


Plan confirmation and effects of plan confirmation are altered in critical ways.  To confirm a traditional Chapter 11 plan, the debtor must have at least one “impaired” class of creditors vote to accept the plan, thereby removing the possibility of a debtor confirming a plan without at least one friendly class supporting the plan.  No such requirement is present in a Subchapter V plan.  In addition, the “absolute priority rule” imposed on traditional Chapter 11 plans as part of a “cramdown” (that is, the ability of a debtor to force creditors to accept treatment under a proposed plan) is modified so that, if a Subchapter V debtor commits all of its “projected disposable income” for payments to creditors under the plan over a period of three to five years, the debtor may receive a discharge of its indebtedness and keep ownership of the restructured company even though unsecured creditors neither receive full payment of what they are owed nor vote to approve the plan.  This is similar to and borrowed from Chapter 13 under the Bankruptcy Code, which governs individual debt adjustment cases.


A standing trustee oversees all cases filed under Subchapter V, much as a standing trustee oversees all individual debt adjustment cases under Chapter 13.  A Subchapter V DIP may be removed for cause just as a Chapter 11 DIP may be removed for such things as fraud or mismanagement.  In a Subchapter V case, if the DIP is removed, the standing trustee takes over the operation of the business.


In short. Subchapter V of Chapter 11 provides a small business debtor a less expensive, more feasible and workable alternative to Chapter 11 or other alternative means of restructuring outside of bankruptcy.


CONCLUSION/TAKEAWAYS


An ABC and a Subchapter V Small Business Reorganization should be considered as possible alternatives by small and medium size businesses that suffer financial distress as a result of the COVID-19 pandemic or for other reasons.  Each of these alternatives can provide a debtor with several advantages over a traditional bankruptcy filing under Chapter 11 or 7.


This article is provided for educational and informational purposes only and is not intended to, and should not be construed as, legal advice.  Readers should consult their lawyer regarding the applicability of the information discussed herein to their particular situation and facts.


 



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