The Impact of Subchapter V, Chapter 11 of the United States Bankruptcy Code on Creditors’ Rights
As the economy recovers from the impacts of the recent pandemic, the United States Bankruptcy Code has seen a much-welcomed addition of enhanced reorganization rules for small business debtors. These changes, implemented via the Small Business Reorganization Act (SBRA) (effective February 19, 2020), created a new Subchapter V under Chapter 11 of the Bankruptcy Code, thereby providing a more streamlined and cost-effective option for small businesses to reorganize their debts. Since its introduction, Subchapter V has quickly become an increasingly popular option for small businesses; in the first nine months of 2023, small business filings under Subchapter V totaled 1,419 cases, a 41 percent increase from the 1,009 cases during the same period last year.
By providing a tailored process for small business reorganization, Subchapter V accounts for the unique intricacies of such businesses and better equips the Bankruptcy Code vis-à-vis the 33.2 million small businesses in America, forming the most substantial portion of the American economy and in total accounting for 99.9 percent of American businesses and 43.5 percent of domestic GDP.
While the benefits of Subchapter V in strengthening debtors’ rights and promoting efficient debtor reorganizations has been much lauded, it prompts the necessary question of whether this comes with a sub-optimal trade-off for the creditors. If so, the introduction of Subchapter V could disrupt the delicate equilibrium that bankruptcy law strives to achieve between debtors’ and creditors’ rights and interests in a reorganization.
How Subchapter V Affects Creditors’ Rights
Compared to traditional Chapter 11 cases, Subchapter V appears to mainly impact creditors’ rights in the following ways:
First, unlike in a traditional Chapter 11 reorganization, Subchapter V provides for the appointment of special Subchapter V Trustees who incur considerably lower fees than Chapter 11 Trustees and play a different role in the reorganization. Unlike the investigative role of Chapter 11 Trustees, Subchapter V Trustees instead play a mediative role and facilitate the development of a consensual reorganization plan. Additionally, Subchapter V Trustees do not possess the typical powers of trustees generally appointed under the Bankruptcy Code. A Subchapter V Trustee does not have the broad powers of a Chapter 11 Trustee, such as operating the debtor’s business and filing a plan. Therefore, unlike Chapter 11 Trustees, Subchapter V Trustees cannot substitute the role of oversight.
Second, Subchapter V requires a debtor to file a reorganization plan within 90 days of the debtor’s filing. Most notably, Subchapter V only grants the ability to file a reorganization plan to the debtor, unlike in traditional Chapter 11 cases where creditors also have the opportunity to file a competing plan that could potentially be more attractive than that of the debtor.
Third, a Subchapter V debtor may confirm a “cramdown” plan without any creditor support. Unlike traditional Chapter 11 cases, Subchapter V does not require at least one impaired class of creditors to approve the plan. Instead, the plan can be confirmed over the objection of creditors if all of the debtor’s disposable income over the course of the plan period will be dedicated to the repayment of unsecured creditors, and that secured creditors will receive the benefit of their security.
Fourth, unlike in traditional Chapter 11 cases, Subchapter V eliminates the need for an unsecured creditors’ committee (absent cause). While a committee can be appointed for cause, the burden and expenses are on individual creditors to assert that a committee is necessary to adequately protect unsecured creditor interests. This creates a more onerous burden on creditors in Subchapter V proceedings and reduces critical creditor oversight of the debtor’s reorganization.
Fifth, the absolute priority rule does not apply in a Subchapter V case. In traditional Chapter 11 plans, the absolute priority rule prevents any creditor of lower priority from being paid if creditors of higher priority are not paid in full. Most significantly, the debtor’s equity holders may not retain any interest in the debtor company if its creditors are not paid in full under the plan. By eliminating the absolute priority rule, unsecured creditors do not have to be paid in full before debtors are allowed to retain their property under a Subchapter V reorganization. Instead, the debtor only needs to establish that the plan is “fair and equitable” and “does not discriminate unfairly,” and that all of its projected disposable income for three years post-emergence will be used to make payments under the plan.
Sixth, unlike other Chapter 11 debtors, Subchapter V debtors do not have to promptly pay post-petition claims. Under traditional Chapter 11 cases, post-petition debts must typically be paid by the debtor either in the ordinary course of business or on the effective date of the plan. Subchapter V instead permits debtors to pay post-petition claims after the plan effective date. Creditors whose debts are reorganized and repaid after the plan effective date hence face a higher risk that their claims will not be repaid in full.
Compared to traditional Chapter 11 cases, Subchapter V seems to impose a greater limitation on creditors’ rights and involvements; a Subchapter V reorganization plan may be approved even if junior creditors receive distributions while senior creditors are impaired, and large creditors lose their blocking votes in the Subchapter V process. Furthermore, against Subchapter V’s rules on “cramdown” and absolute priority, debtors may exploit the definition of “disposable income” to their advantage. While projected disposable income is not defined, “disposable income” is defined in §1191(d) of the Bankruptcy Code as income “not reasonably necessary to be expended … for the continuation, preservation, or operation of the business of the debtor.” Consequently, debtors may be incentivized to allocate much of their business income to the “continuation, preservation or operation” of the business to avoid higher payments to creditors.
Notwithstanding the aforementioned, Subchapter V remains a welcomed development in America’s bankruptcy ecosystem, in light of the vital role small businesses play in the American economy. As Subchapter V develops past its infancy, practitioners and judiciaries will, over time, be faced with the opportunity to clarify the contours of its application. In the meantime, creditors should be mindful of their rights and challenges presented under the framework. Given the expedited timeframe of Subchapter V reorganizations, it is important for creditors to stay informed of reorganization proceedings and involve themselves as early as possible.
Wendy Fu is presently pursuing her LL.M. at New York University School of Law with a specialization in Corporation Law. She is a Graduate Editor for the NYU Journal of Law and Business and serves as a Student Representative of the LL.M. Class of 2024. She graduated with her LL.B. from Singapore Management University with honors, where she worked as a Research Assistant in both the Singapore International Dispute Resolution Academy and the Singapore Global Restructuring Initiative. Prior to commencing her LL.M., she undertook legal traineeship in a boutique corporate law firm in Singapore accredited under Chambers and IFLR1000, specializing in corporate finance, mergers and acquisitions, IPOs, securities, and insolvency and restructuring.