The Future Of Small Business Bankruptcies And Creditors’ Committees After The SBRA: In Re Bonert And In Re Lear Capital – Insolvency/Bankruptcy -…

With the passage of the Small Business Reorganization Act (the"SBRA") in 2019,1 Congress made significantchanges to the Bankruptcy Code2 that affect smallbusinesses.3 These changes include removing theappointment of a creditors' committee as a matter of course forsmall businesses and the creation of subchapter V,4 anew, additional, and streamlined bankruptcy option for eligiblesmall businesses.5 Two recent cases, In reBonert6 and In re Lear Capital,Inc.,7 offer an opportunity to examine thesechanges and may offer insight into what lies in store for smallbusiness chapter 11 bankruptcy cases.

Congress has long attempted to assist small businesses seekingto reorganize rather than liquidate their business. In 1994, theBankruptcy Reform Act8 created the "small businessdebtor" designation and procedures applicable to qualifyingdebtors, which the Bankruptcy Abuse Prevention and ConsumerProtection Act of 2005 ("BAPCPA")9 modified.However, while such Acts introduced various procedural protections,the substantive statutory regime for small business debtors largelymirrored the regime in place for traditional chapter 11 debtors,including its administrative costliness andcomplexity.10 Accordingly, the changes introduced in1994 and 2005 proved largely ineffective to reduce the costsassociated with the administration of chapter 11 cases, and manysmall business reorganizations failed.11

The SBRA amended the provisions of the Bankruptcy Code,introducing several substantive changes to the provisions affectingsmall businesses. Two notable changes are: (1) the creation ofsubchapter V, a streamlined alternative to a traditional smallbusiness chapter 11 case; and (2) the modification of the proceduresurrounding the appointment of creditors' committees in smallbusiness and subchapter V cases.

The SBRA introduced a new type of chapter 11 case, called asubchapter V case, for eligible small businesses that electsubchapter V designation. Subchapter V cases differ from smallbusiness cases in several ways.12 For example, the SBRAprovides for the appointment of a subchapter V trustee, who doesnot displace management in the operation of the debtor, to assistin developing a consensual restructuring plan.13 Inaddition, subchapter V debtors face stricter timelines than smallbusiness debtors, encouraging a prompt confirmation process andreducing the administrative costs associated with lengthier chapter11 cases.14

Additional advantages of subchapter V for debtors include: (a)equity holders' ability to retain their ownership interestswithout paying all creditors in full (elimination of the"absolute priority rule");15 (b) eliminationof the general requirement to file a disclosurestatement;16 (c) the subchapter V debtor's exclusiveright to file a plan;17 and (d) the ability to confirm aplan even if all classes reject the plan so long as the plan doesnot discriminate unfairly, is fair and equitable to any dissentingclass, and the debtor commits its projected disposable income (orthe value thereof) for a period of three to five years todistributions to creditors.18 In addition, in order toalleviate the costs of chapter 11 administration, subchapter Vdebtors do not have to pay quarterly U.S. trustee fees19and are allowed to pay administrative expenses over time under aplan.20

The SBRA, as originally enacted, provides that thequalifications to be a subchapter V debtor are the same as for anysmall business debtor.21 However, the Coronavirus Aid,Relief, and Economic Security ("CARES") Act temporarilyincreased the debt limit for subchapter V debtors to$7,500,000.22 This temporary increase has been extendedtwice,23 with the current extension set to sunset onJune 21, 2024.

The SBRA alters the appointment of creditors' committees insmall business chapter 11 cases. In traditional chapter 11 casesand small business cases before the enactment of the SBRA, theUnited States Trustee ("UST") is required to appoint acommittee of general unsecured creditors to represent the interestsof general unsecured creditors.24 The UST may alsoappoint additional creditors' or equity holders' committeesas appropriate.25 The bankruptcy court may also order,upon request, the appointment of additional committees "toassure adequate representation of creditors or of equity securityholders."26

Whereas, before the SBRA, a party in interest could request thatno creditors' committee be appointed in a small business case,under the SBRA a committee is only appointed in either a smallbusiness or subchapter V case if a court so orders "forcause" shown.27 In at least one case,Bonert, the court held that where a debtor opted forsubchapter V treatment after the passage of the SBRA, acreditors' committee that had been appointed before thesubchapter V designation would not be automatically grandfatheredin, but instead needed to show cause why it ought to remain inplace after the case became a subchapter V case.28

Creditors' committees possess a number of powers andresponsibilities.29 These include: (1) consulting withthe chapter 11 trustee or the debtor in possession;30(2) investigating the debtor or its businessactivities;31(3) participating in the formulation of achapter 11 plan;32 and (4) requesting the appointment ofa chapter 11 trustee or an examiner.33 Many courts haveheld that creditors' committees may seek "derivativestanding" from the bankruptcy court to bring actions to avoidfraudulent or preferential transfers on behalf of a debtor inpossession who unjustifiably refuses to do so.34 Inaddition, a creditors' committee may employ professionals suchas attorneys and accountants to represent it or perform services onits behalf.35

Creditors' committees can pose challenges in small businessand subchapter V cases. From a practical perspective, excessivelyadversarial participation by a creditors' committee can hinderor delay confirmation of a plan of reorganization. From anadministrative perspective, a creditors' committee can becostlyits retained professionals' fees are paid, withcourt approval, from the debtor's estate.36 Suchadministrative expenses receive priority in payment (i.e., they arepaid off before most kinds of debts) and thereby leave fewer fundsavailable for distribution to unsecured creditors under adebtor's plan. A chapter 11 case without a creditors'committee will reduce costs, arguably facilitating the ability ofdebtors to more quickly formulate and fund their plans.Accordingly, changing the default so that no creditors'committee is automatically appointed in small business andsubchapter V cases forces interested parties to justify theattendant cost as compared to any benefit.37

A creditors' committee may still be appointed "forcause."38 The SBRA does not define"cause," and no published cases have yet attempted todefine "cause" in small business or subchapter V cases.The Lear Capital case, in which the Bankruptcy Courtordered the appointment of a creditors' committee, offers anopportunity to examine the issues that might inform future courtsthat address the issue of "cause" in small business andsubchapter V cases.

Lear Capital, Inc. ("Lear") is a metal and coininvestment firm. In the years before its subchapter V chapter 11bankruptcy filing, Lear had reached settlements with the LosAngeles City Attorney's Office and the State of New Yorkregarding its alleged business practices. In anticipation offurther legal action by government agencies and customers, Learsought chapter 11 bankruptcy relief to resolve potential claims ina single forum.

A group of Lear's customers sought the appointment of anofficial committee of unsecured creditors to represent theinterests of Lear's customers, most of whom had insufficientresources to effectively hire their own representation to protecttheir interests in the case.39 The customers' motionfurther argued that other parties, such as the government agenciesthat were pursuing their own claims against the debtor, and thesubchapter V trustee, whose role was not to advocate for anyparticular group of creditors, could not adequately provide a"voice" for customers.

Lear initially opposed the appointment of a creditors'committee.40 It contended that Congress intended theappointment of a creditors' committee "only in rare andunusual circumstances." Lear also argued that oversight fromthe UST and the involvement of the subchapter V trustee and severalstate agencies provided sufficient oversight of the debtor.Moreover, Lear argued that, because a subchapter V debtor canconfirm a plan without the acceptance of an impaired class if itcommits its projected disposable income for three to five years todistributions to creditors, a creditors' committee could notresult in creditors receiving more under a plan; rather, thecommittee's professional fees could only reduce the amountavailable to creditors.

Despite these initial objections, Lear ultimately submitted forcourt approval a settlement with state agencies and customers thatwould provide for, among other things, the appointment of acommittee of customer creditors.41 On June 23, 2022, theBankruptcy Court approved the settlement.42

Although the court did not have to address what might constitute"cause" for the appointment of a committee under theSBRA, the case highlights various issues that may prove critical infuture cases.

Different Standards for Small Business Cases andSubchapter V Cases

The Bankruptcy Code does not distinguish between small businesscases and subchapter V cases in mandating that a creditors'committee not be appointed except for cause shown. This suggeststhat the distinctions between small business cases and subchapter Vcases should not result in different standards for what constitutes"cause." However, Lear Capital raises thepossibility that courts may develop separate tests for smallbusiness and subchapter V cases to determine whether"cause" to appoint a creditors' committee exists.Lear (a subchapter V debtor) made two arguments against appointinga creditors' committee that would be inapplicable to a smallbusiness case: (1) that the subchapter V trustee can providenecessary oversight, and (2) that the ability to confirm a planover creditors' objections and to commit three to fiveyears' worth of projected disposable income to distribution tocreditors eliminates the ability of creditors' committees tomaximize payment in favor of their constituents.

A comparison of Lear Capital with Bonertsuggests that the appointment of creditors' committees will bestrongly disfavored, but that there may be instances, such as inLear Capital, where the need for a subset of creditors tohave a voice may constitute cause to appoint a committee. InLear Capital, the customers' motion sought, and Learultimately agreed to, the appointment of a special committee torepresent customers' interests. In Bonert, however,the committee appointed and eventually disbanded was a generalcommittee of unsecured creditors.

Lear Capital may prove to be unique given certainunderlying factors. Unlike "the typical bonafide Chapter 11case, [in which] the debtor is dealing with tradecreditors,"[43] Lear sought bankruptcy relief to addressanticipated legal claims in a single forum. Had these claimsreached judgment and become liquidated prepetition, Lear would haveexceeded even the increased debt limit for subchapter V cases andwould have had to proceed in a traditional chapter 11 case.Arguably there would have been a strong basis for the BankruptcyCourt to find "cause" given that: (1) there is a largeclass of similarly situated creditors holding contingent,unliquidated claims; (2) their claims, if they had becomenon-contingent and liquidated prepetition, would have rendered thedebtor ineligible to be a small business or subchapter V debtor;and (3) use of the bankruptcy forum to settle or litigate theclaims was a primary motivation for the bankruptcy filing.

It is too early to tell whether the Lear Capital casewill remain an exception or become the rule and creditors'committees become more commonplace in the post-SBRA world.Nevertheless, the outcome in Lear Capital suggestspossibilities for what the future holds for creditors'committees in small business and subchapter V cases.

Footnotes

1. Pub. L. No. 116-54 (August 23, 2019).

2. 11 U.S.C. 101 et seq.

3. Prior to the SBRA, section 101(51D)(A) of theBankruptcy Code defined a "small business debtor"as:

[A] person engaged in commercial or business activities... that has aggregate noncontingent liquidated secured andunsecured debts as of the date of the filing of the petition or thedate of the order for relief in an amount not more than $2,000,000[as adjusted pursuant to 11 U.S.C. 104] ... for a case inwhich the United States trustee has not appointed under section1102(a)(1) a committee of unsecured creditors or where the courthas determined that the committee of unsecured creditors is notsufficiently active and representative to provide effectiveoversight of the debtor[.]

The current definition is:

[A] person engaged in commercial or business activities... that has aggregate noncontingent liquidated secured andunsecured debts as of the date of the filing of the petition or thedate of the order for relief in an amount not more than $3,024,725[adjusted effective April 1, 2022] (excluding debts owed to 1 ormore affiliates or insiders) not less than 50 percent of whicharose from the commercial or business activities of thedebtor[.]

4. 11 U.S.C. 11811195.

5. The Bankruptcy Code as amended by the SBRA defines a"small business case" as "a case filed under chapter11 of this title in which the debtor is a small business debtor andhas not elected that subchapter V of chapter 11 of this title shallapply." 11 U.S.C. 101(51C). Eligible debtors may pursuesmall business bankruptcies without opting for subchapter Vtreatment. Accordingly, for simplicity, this article uses"small business case" and "small businessdebtor" to refer only to cases and debtors, respectively, thatare not proceeding under subchapter V, and uses "subchapter Vcase" and "subchapter V debtor" to refer,respectively, to cases and debtors under subchapter V.

6. Case No. 2:19-bk-20836-ER (Bankr. C.D.Cal.).

7. Case No. 1:22-bk-10165-BLS (Bankr. D.Del.).

8. H.R. 5116, Pub. Law No. 103-394 (October 22,1994).

9. Pub. L. No. 1098 (April 20, 2005).

10. These procedural changes include: (1) a longer"exclusivity period," during which only the debtor mayfile a plan; (2) the ability of a debtor to seek conditionalapproval of the disclosure statement, with final approval to followat a hearing before or combined with the hearing on confirmation;and (3) tighter deadlines to file the disclosure statement and planand confirm the plan. See 11 U.S.C. 1121(e)(1)-(2) & 1129(e); Fed. R. Bankr. P. 3017 & 3017.1.A disclosure statement is a statement filed by a debtor, or otherparty that has proposed a plan, that describes the contents of theplan. See 11 U.S.C. 1125.

11. See In re Wright, No. CV20-01035-HB, 2020 WL 2193240, at *3 n.6 (Bankr. D.S.C. Apr. 27,2020) (noting small business debtors' difficulties inreorganizing even after BAPCPA) (citing Report from the HouseCommittee on the Judiciary (Report No. 116-54)).

12. For a more extensive overview of these differences,see In re Seven Stars on the Hudson Corp., 618B.R. 333, 340 (Bankr. S.D. Fla. 2020).

13. 11 U.S.C. 1183(b)(7). In a small businesscase, a trustee (who would displace management) is only appointedupon a showing of fraud, mismanagement, or similarproof.

14. See, e.g., 11 U.S.C. 1189(b)(requiring debtor to file a plan "not later than 90 days afterthe order for relief under this chapter," and only allowingthe court to extend the time to file a plan "if the need forthe extension is attributable to circumstances for which the debtorshould not justly be held accountable").

15. 11 U.S.C. 1181(a), 1191(b).

16. 11 U.S.C. 1191(b).

17. 11 U.S.C. 1189(a).

18. 11 U.S.C. 1191(b).

19. 28 U.S.C. 1930(a)(6)(A).

20. 11 U.S.C. 1191(e).

21. See 11 U.S.C. 1182(1) (providingqualifications to be subchapter V debtor); In re RS Air,LLC, 638 B.R. 403, 409 (B.A.P. 9th Cir. 2022) (noting that theSBRA "as originally enacted defined the debtor under 101(51D), in the same way as a small business debtor who does notelect to proceed under subchapter V").

22. See RS Air, LLC, 638 B.R. at 409(noting that the SBRA "as originally enacted defined thedebtor under 11 U.S.C. 101(51D), in the same way as a smallbusiness debtor who does not elect to proceed under subchapterV") (citing Pub. L. No. 116-136, 134 Stat. 281 (Mar. 27,2020)).

23. See id. (citing Pub. L. No. 117-5 (Mar. 27,2021) (the "COVID-19 Bankruptcy Relief Extension Act of2021") and Pub. L. No. 117-151 (S. 3823) (June 21, 2022) (the"Bankruptcy Threshold Adjustment and Technical CorrectionsAct")).

24. 11 U.S.C. 1102(a)(1). Inpractice, the UST will fulfill this duty by analyzing the need forsuch a committee and, where appropriate, appoint such committee, orotherwise inform the Court that the UST was unable to doso.

25. Id.

26. 11 U.S.C. 1102(a)(2).

27. 11 U.S.C. 1102(a)(3).

28. See In re Bonert, 619 B.R. 248, 254(Bankr. C.D. Cal. 2020) ("[T]he Court will provide theCommittee an opportunity to show cause why it should be permittedto continue in existence after the Debtors' Subchapter Velection takes effect."). In subsequent briefing, thesubchapter V trustee argued that his role and the role of acommittee would be duplicative. In light of the subchapter Vtrustee's brief, the committee did not oppose disbandment, andthe court entered an order disbanding the creditors' committee.See In re Bonert, Case No. 2:19-bk-20836-ER(Bankr. C.D. Cal.), Docket Nos. 277 (June 18, 2020) (subchapter Vtrustee's brief), 278 (June 19, 2020) (creditors'committee's statement that it did not object to disbandment)& 287 (July 10, 2020) (order disbanding thecommittee).

29. 11 U.S.C. 1103(c).

30. 11 U.S.C. 1103(c)(1).

31. 11 U.S.C. 1103(c)(2).

32. 11 U.S.C. 1103(c)(3).

33. 11 U.S.C. 1103(c)(4).

34. See, e.g., In re Roman Cath. Diocese ofHarrisburg, 640 B.R. 59, 67 (Bankr. M.D. Pa. 2022) (citingCybergenics Corp. ex rel. Cybergenics Corp. v. Chinery,330 F.3d 548, 553 (3d Cir. 2003)); In re Roman Cath. Bishop ofGreat Falls, Montana, 584 B.R. 335, 338 (Bankr. D. Mont. 2018)(citing In re Valley Park, Inc., 217 B.R. 864, 866 (Bankr.D. Mont. 1998)); In re Dzierzawski, 518 B.R. 415,41719 (Bankr. E.D. Mich. 2014) (discussing Sixth Circuitcases).

35. 11 U.S.C. 1103(a).

36. 11 U.S.C. 330(a), 503(b).

37. 11 U.S.C. 1102(a)(3).

38. Id.

39. Case No. 1:22-bk-10165-BLS (Bankr. D. Del.), DocketNos. 130 (April 20, 2022) (motion) & 175 (May 2, 2022) (replybrief).

40. Case No. 1:22-bk-10165-BLS (Bankr. D. Del.), DocketNos. 133 (April 20, 2022) (objection to motion to shorten time)& 171 (April 30, 2022) (opposition brief).

41. Case No. 1:22-bk-10165-BLS (Bankr. D. Del.), DocketNo. 241 (June 7, 2022).

42. Case No. 1:22-bk-10165-BLS (Bankr. D. Del.), DocketNo. 251 (June 23, 2022).

43. In re Albrechts Ohio Inns, Inc., 152 B.R.496, 502 (Bankr. S.D. Ohio 1993).

The content of this article is intended to provide a generalguide to the subject matter. Specialist advice should be soughtabout your specific circumstances.

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The Future Of Small Business Bankruptcies And Creditors' Committees After The SBRA: In Re Bonert And In Re Lear Capital - Insolvency/Bankruptcy -...