Bankruptcy; for all the hope and relief it can offer a business with mounting debts, it is nonetheless a confusing topic made all the more perplexing by the labyrinth of legal codes surrounding it. There is more than one kind of bankruptcy, after all, and it can be difficult for a business owner to decide between them.
Making sense of it all can be overwhelming. Hopefully, this short explainer will help you distinguish between the various types of legally recognized bankruptcies. Remember, though, you will need to consult with a knowledgeable attorney to determine which path is best for you.
Bankruptcy law is governed by Title 11 of the U.S. Code which was enacted in 1978. In 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act (“BAPCPA”) amended the Code. There is also the Federal Rules of Bankruptcy Procedure and local rules that must be followed during bankruptcy proceedings.
Article I, Section 8, of the U.S. Constitution authorizes Congress to enact "uniform Laws on the subject of Bankruptcies." Accordingly, Congress has the constitutional authority to enact laws relating to bankruptcy. Because this power is expressly given to the Federal government, the states do not have the ability to enact their own bankruptcy laws that conflict with Federal law. Simply, bankruptcy is governed by federal law created by Congress. Under this grant of authority, Congress enacted the "Bankruptcy Code" in 1978 as a part of bankruptcy reform. The “Code” is still in use today but has evolved significantly over time.
However, this does not necessarily mean that bankruptcy works exactly the same way in every state. The states always reserve the right to address issues and concerns that not have not been covered by federal law. For this reason, some states have additional rules governing the debtor-creditor relationship. These rules naturally vary from state to state.
In 2019, Congress passed amendments to the Bankruptcy Code known as the Small Business Reorganization Act (SBRA). The SBRA became law in August of 2019. Before SBRA, struggling businesses considering bankruptcy had two avenues for reorganization: chapter 7 or chapter 11.
Upon the filing of a chapter 7 case, a bankruptcy estate is created that is comprised of the debtor’s nonexempt property. A trustee is appointed to liquidate the assets of the bankruptcy estate and distribute the proceeds to the debtor’s creditors. Chapter 7 is not an option for businesses hoping to survive bankruptcy and retain control of their operations.
In contrast, a chapter 11 debtor retains control over its operations and restructures its debts through a court-approved plan. However, it has long been known that the high costs and complexities of “chapter 11” reorganizations can make it too difficult for small businesses to successfully reorganize through bankruptcy. Although the chapter 11 debtor retains control, the debtor is subject to increased oversight from the bankruptcy court and the U.S. trustee.
The chapter 11 debtor's plan to repay its debts must meet stringent requirements and be confirmed (i.e., approved) by the bankruptcy court before the debtor can exit bankruptcy. While in bankruptcy, the debtor is required to obtain the court's approval of all non-ordinary course-of-business transactions and must comply with the U.S. trustee's monthly reporting requirements. As a result, a small business may not be able to afford the costs of chapter 11.
The SBRA endeavors to strike a balance between chapter 7 and chapter 11. Under the SBRA, certain debtors can retain control over their business operations while reorganizing. However, they will no longer be subject to the more costly requirements in chapter 11. Unlike chapter 11, a trustee will be appointed to each small-business debtor case. In addition, the SBRA provides that a committee of creditors will not be appointed unless ordered by the bankruptcy court for cause. This provision usually decreases the costs of a chapter 11.
Many of the SBRA’s amendments streamline the plan confirmation process and potentially reduce plan confirmation costs. In a chapter 11 case, the debtor must file a disclosure statement with the bankruptcy court. The disclosure statement is a detailed document intended to inform creditors of key provisions in the debtor’s plan. It must be approved by the bankruptcy court.
However, under the SBRA, a debtor will generally not be required to prepare a disclosure statement. The SBRA permits only the debtor the exclusive right to file a plan of reorganization. This elimination of a disclosure statement and potential competing plans often prevents contested hearings that prolong the reorganization process and increase costs for debtors.
The SBRA also loosens the requirements to confirm a plan. Simply stated, a plan is generally confirmed if it provides that all projected disposable income for three to five years will be used to make plan payments. In addition, the required plan contents under the SBRA are less stringent than those for chapter 11 plans. There is a caveat with regards to the SBRA, however. Because of its relative leniency, the restructured debt cannot be overly burdensome. For that reason, SBRA coverage only applies to small business owing less than $2,725,626.
Ultimately, by cutting costs and simplifying the process, the SBRA aims to provide another option for small businesses wishing to reorganize. It prevents the necessity of liquidating assets while simultaneously avoiding the high costs associated with a chapter 11 creditor payment plan.
Although there have been minor changes over time, the Bankruptcy Code was overhauled in 2005 under the BAPCPA in which Congress addressed different abuses in the bankruptcy system. Recently, the CARES Act, passed in 2020, provides temporary relief to some debtors in response to COVID-19. Most of these provisions, though, only apply to individual wage-earners, who typically file for bankruptcy under chapter 13 provisions.
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