A new bankruptcy law could prove a big help for small businesses. Here’s everything you need to know
May 11, 2020 6:00 AM AST
As the coronavirus shutdowns continue to strain companies across the U.S., many small businesses are now facing a tough decision: whether or not to file for bankruptcy. While programs like the Paycheck Protection Program and Economic Disaster Injury Loans (via the Small Business Administration) have attempted to save employees and keep businesses alive, new data suggests that over 40% of the 30 million small businesses in the U.S. could shutter permanently in the next six months, according to a poll by the U.S. Chamber of Commerce. It's what Amanda Ballantyne, executive director of Main Street Alliance, an advocacy group for small business, said was "a crisis that will impact our economy for generations. We’re going to lose so much of the small-business sector." Yet bankruptcy could help many of these companies survive the pandemic—especially as a new law makes it easier for small businesses to access it. In previous years, reorganizing via bankruptcy was less tenable for small businesses. Chapter 11, which is basically a reorganization of the business, has long been what attorneys like Lance Martin, a bankruptcy lawyer at Ward and Smith, classify as an "onerous and expensive and lengthy process." The original Chapter 11 is more "intended for railroads and big business and airlines and Sears," says Andrew Houston, a partner focused on bankruptcy at Moon Wright & Houston, based in North Carolina. But in February, a new subchapter was serendipitously added to Chapter 11, under the Small Business Reorganization Act (SBRA), called Subchapter 5—which caters to small businesses whose time and resources are more limited. The new code significantly cuts down on the time and money typical bankruptcy cases take. Under the code, companies with under $2.7 million in debt can be eligible—And now, as part of the $2.2 trillion CARES Act, that threshold is raised to $7.5 million for one year to cover more businesses. For many of those small businesses right now, bankruptcy might be a beneficial option. "It’s kind of like making a calculated retreat. You’re retrenching, you're going to figure out what’s the core of your business that was profitable," says Amy Vulpio, a bankruptcy attorney at law firm White and Williams, based in Pennsylvania. For small businesses who may need to consider this option in the near future, Fortune asked three attorneys what you should consider.
Is bankruptcy going to help me save my business?
Lawyers say a key thing to consider when thinking about bankruptcy is which tools it can offer your business, and which it can't.
Chapter 11 bankruptcy is designed to help you restructure your business, which can help in reducing (or eliminating) debt, focusing on profitable parts of the business, selling off parts, and buying time to reconfigure operations. It won't, however, attract customers or help you generate revenue.
"It’s not going to fix problems like if they didn’t have any customers before the bankruptcy or before [COVID-19]," says Vulpio.
Part of filing for bankruptcy is creating a business plan outlining your projected income and how you'll pay your creditors back. Bankruptcy is intended to help companies that will be able to stay cash flow positive once their debts are reduced or eliminated, so that is key to consider beforehand. "You really need to do some pre-bankruptcy planning to think about, how can you generate revenue on a going-forward basis to support a plan that’s going to be feasible?" notes Martin. Especially coming out of coronavirus shutdowns, businesses need to have a clear picture of how they can snapback their business and generate enough revenue, and how reorganizing via bankruptcy could help them reach those goals.
What are the benefits of bankruptcy?
The primary benefit of bankruptcy is straightforward: through something called the ‘automatic stay,’ filing for bankruptcy stops all your creditors from coming after you.
"If you’re being foreclosed on or your landlord is trying to evict you or you’re being sued, all of that has to stop and all of the creditors have to come in and deal with you in the bankruptcy court," Martin tells Fortune. "It eliminates death by a thousand cuts if you're fighting a battle on several different fronts."
For many small businesses unable or struggling to stay open right now, like retailers, bars, and restaurants, bankruptcy might be a good way to get through some uncertainty by pausing or getting rid of some of their obligations—especially leases, Vulpio points out.
Will I have to pay back all my debts?
But, of course, you will have to present a plan on how you'll repay your creditors. A major provision in Subchapter 5 is that debtors can restructure (or eliminate) debt by using their projected disposable income (net operating income) to pay creditors back over three to five years.
"Just think about it like a payment plan with your creditors," notes Houston.
As part of a bankruptcy plan, businesses will have to propose what they project they'll have as disposable income over the next three years, and how it will be doled out to different creditors. "If you comply with a plan like that, then you can essentially eliminate your debts after a three to five year period," Martin says.
Will I still own my business after bankruptcy?
In a regular Chapter 11 reorganization, business owners would typically need to get new funding to confirm their bankruptcy plan, and they usually don't get to keep a stake in the reorganized business unless debts are repaid in full.
One notable change in Subchapter 5: small business owners can keep their equity, meaning they're still able to hold on to their business, as long as they distribute their disposable income to creditors over the next three to five years.
That's a huge plus for small business owners (who often own more of their business than a large company with many shareholders) and gives business owners a much better shot at keeping their equity interest. "That’s the whole point here, to rehabilitate," Vulpio notes.
Do my creditors have to approve my plan?
Unlike regular Chapter 11, under Subchapter 5 you don't need creditors to vote to approve your reorganization plan: "You just have to meet certain thresholds that exist regarding how you treat secured and unsecured creditors," Houston points out, and get the court to approve your plan based on that criteria. That makes the process a lot more debtor-friendly, attorneys say.
Plus, one benefit of Subchapter 5 is that businesses are provided a special Subchapter 5 trustee, which basically acts as a mediator between the debtor and creditors. "If you’re a mom-and-pop, the Subchapter 5 trustee is going to be there to hold your hand and your attorney’s hand through the process," says Martin.
How will bankruptcy affect PPP loans?
There's no promise of future loan or stimulus programs like the Paycheck Protection Program, but it is important to note that businesses that have filed for bankruptcy aren't eligible for the PPP loan under current (and changing) SBA guidelines.
If future rounds of stimulus (in whatever forms they take) do become available, bankruptcy might make it harder to access those, Vulpio suggests. Yet, she maintains: “Businesses have to make the best decision with the information they have now and try not to get hung up on what could hypothetically happen."
Meanwhile, Houston believes business owners need to think about their immediate needs: "If you’re three months behind on your rent, or you owe money to trade creditors, et cetera, the PPP proceeds aren’t going to help you very much."
For those businesses who already have a PPP loan and are considering filing for bankruptcy, things get pretty fuzzy. According to Vulpio, "Once you’ve had the funds, it appears you can then file, but all these rules are constantly changing." Current SBA guidelines indicate that if an applicant is a debtor in a bankruptcy case at the time they apply for the PPP loan or before funds are distributed, they need to notify their lender and cancel their application, but there hasn't been clear guidance about what happens after you receive funds.
What if I just want to walk away from my business?
In that case, you're looking at a Chapter 7 bankruptcy, where "you're essentially walking away from your business," says Vulpio. Individuals and businesses can use Chapter 7 to wipe out debt, but they're also liquidating the business.
Most businesses likely don't want to have to shutter when put in a difficult situation like the coronavirus crisis. But there will be businesses whose best option is to walk away—and that's where Chapter 7 comes in.
Another path is that a business can decide to turn a Chapter 11 into a Chapter 7 if they decide midway the business isn't viable to keep running. Adds Martin: "Any business owner needs to think long and hard about the viability of their business on the going-forward basis. If they're determined that, 'we were limping along before the virus or we were ready to retire' or whatever it is, and they don’t think that the business can survive or they can sell the business in this market, then Chapter 7 may be an option."
Will I need to file for personal bankruptcy too?
Plenty of small businesses use personal guarantees or collateral to back up loans. But filing for Chapter 11 for your business won't necessarily stop your creditors from coming after you.
When weighing the option of filing for bankruptcy, small business owners should consider "where their personal liability is vis a vis the business," and what kind of personal guarantees or collateral they have in loans, notes Martin. Some business owners may need to file personal bankruptcy too, in order to help restructure their own debt. In fact, Subchapter 5 and Chapter 11 are also available to individuals whose debts are mainly tied to commercial or business activities.
However, there is an opportunity under Subchapter 5 to modify certain residential mortgages for small business owners if used as collateral for business loans. But if you're filing for Chapter 7, you might have less luck.
Keep in mind...
All the experts Fortune spoke to stressed that bankruptcy should always be a last resort. Martin highly recommends working with your creditors to try to come to some agreement, deferment, or payment plan outside bankruptcy court: "That will save you time and money," he says. Plus, creditors would "much rather just get paid, and if they have to modify their loans or defer for a time, I find they’re inclined to do that."
If you're thinking about future growth, you'll need to work it into your plan—"One of the questions I hear debtors have is, 'well how do we then build something in for future growth? We want to be able to grow the business, does this tie up all the money we could possibly use for that?'" Vulpio says. She suggests having that be part of the thought process for your plan in bankruptcy proceedings.
One plus for Subchapter 5 is the process will likely be faster, but that also might put some small businesses in a time crunch to get the right documents in order. Debtors now have to file a Chapter 11 (Subchapter 5) plan within 90 days of filing for bankruptcy (it used to be 120 days). If you do need to file, it's going to go quick—so Martin suggests doing some pre-planning with your CPA beforehand.
And while the word "bankruptcy" does carry a lot of negative connotations, some attorneys note that the stigma likely won't be quite the same during coronavirus. Unlike the slew of bankruptcies that followed the 2008 financial crisis, Martin says "This situation feels different. It feels like businesses have been caught in a buzzsaw" amid government-enforced shutdowns. He adds: "I’d like to think that the capital markets and banks and investors and other businesses are going to frankly be pretty understanding that some businesses may have had no choice."