Bankruptcy Judge Robert E. Grossman of Central Islip, N.Y., wrote the most thorough survey so far regarding a debtor’s ability to use the new Small Business Reorganization Act to propose a plan that would not be possible in an “ordinary” chapter 11.
In his April 10 opinion, Judge Grossman allowed the debtor to elect treatment under the SBRA 15 months after filing a chapter 11 reorganization that was on the verge of failure. He also laid down standards for deciding when a debtor can modify the mortgage on a property used for both residential and business purposes.
The President signed the SBRA into law on August 23. It became effective on February 19. The SBRA is codified as subchapter V in chapter 11, 11 U.S.C. §§ 1181 – 1195.
The Traditional Chapter 11 Was Failing
The debtor had purchased an historic mansion and converted the property to bed and breakfast lodging. As the local law required, she lived in the facility as her principal residence.
As a result of a previous bankruptcy, the debtor no longer had personal liability on the mortgage, which had an outstanding balance of about $1.7 million in principal and interest. The property was worth somewhere in the neighborhood of $1 million, according to the debtor.
On and off, the mortgage had been in default for years. On the verge of foreclosure, the debtor filed a chapter 11 petition in October 2018, but she did not designate herself at the time as a small business debtor.
The debtor had filed a plan proposing to reduce the mortgage to about $1 million, but Judge Grossman had ruled that her plan was nonconfirmable under Section 1123(b)(5), which precludes impairing the mortgage on property that is the debtor’s principal residence.
Meanwhile, the debtor’s exclusive right to file a plan had terminated. The mortgagee filed a plan calling for the sale of the property and had obtained the votes from unsecured creditors necessary for confirmation. The mortgagee’s plan was set for confirmation on February 26, 2020, seven days after the SBRA became effective on February 19.
Judge Grossman adjourned the confirmation hearing, allowing the debtor an opportunity to amend the petition to designate herself as a small business debtor under the newly effective subchapter V of chapter 11.
Naturally, the debtor amended her petition, but the mortgagee and the U.S. Trustee both objected to treatment under the SBRA.
Eligibility for the SBRA
To be eligible for treatment as a small business debtor under the SBRA as it was originally written, the debtor must have had aggregate, noncontingent, liquidated secured and unsecured debt of less than $2,725,625. See Section 101(51D).
In response to the coronavirus emergency, the President signed the $2 trillion Coronavirus Aid, Relief and Economic Security Act. Known as the CARES Act, the law became effective on March 27. Among other things pertaining to bankruptcy, the CARES Act raised the SBRA debt cap for one year to $7.5 million.
The debtor had less than $100,000 in debt other than the mortgage, so she fell well below the monetary cap for a small business debtor.
The U.S. Trustee argued that “procedural issues” nevertheless precluded use of the SBRA. Among other things, the SBRA requires holding a status conference within 60 days of the order for relief and filing a plan within 90 days of the order for relief. Since the order for relief was 15 months before redesignation as a small business reorganization, the U.S. Trustee believed that the debtor did not comply with the deadlines.
Judge Grossman noted that both deadlines may be extended under “circumstances for which the debtor should not be held accountable.” See Sections 1188(b) and 1189(b). Judge Grossman dispensed with the U.S. Trustee’s argument, saying that requiring compliance “with the procedural requirements of a law that did not exist is the height of absurdity.”
The Lender’s Arguments
Lodging more substantive arguments, the mortgagee contended that allowing the debtor to proceed under the SBRA would prejudice its “vested rights,” such as the ability to confirm a plan. Moreover, Judge Grossman had already approved the mortgagee’s disclosure statement, and the lender had votes in hand sufficient for confirmation.
Under the SBRA, only the debtor may propose a plan. See Section 1189(a). Consequently, the mortgagee would lose the ability to propose or confirm a plan if the debtor could proceed under the SBRA.
Dealing with the applicability of the SBRA to pending cases, Judge Grossman followed In re Moore Properties of Person County LLC, 20-80081, 2020 WL 995544 (Bankr. M.D.N.C. Feb. 28, 2020). In Moore, Bankruptcy Judge Benjamin A. Kahn of Greensboro, N.C., ruled that the redesignation of a typical small business case under the SBRA does not impair a creditor’s constitutional or property rights. Id., 2020 WL 995544, at *4. To read ABI’s report on Moore, click here.
Section 1190(3): The ‘Magic’ in the SBRA
For Judge Grossman, the “difficult question” revolved around the debtor’s avowed intention to use Section 1190(3). Notwithstanding Section 1123(b)(5), which had barred confirmation of the debtor’s ordinary chapter 11 plan, Section 1190(3) allows a small business debtor to modify a mortgage on the debtor’s principal residence if the loan was “(A) not used primarily to acquire the real property; and (B) used primarily in connection with the small business of the debtor.”
Under the mortgagee’s chapter 11 plan, the lender would have been entitled to sell the property. Since the lender’s personal claim against the debtor had been discharged previously, the lender only had the ability to realize the value of the property if it were able to confirm its plan.
Therefore, Judge Grossman said, Section 1190(3) “will not deprive [the lender] of any rights [the lender] retained under state law.” In addition, the lender still had “all rights granted to a secured creditor under the Code that have not been amended by the SBRA.”
In dicta, Judge Grossman went on to say he was “not convinced that 11 U.S.C. § 1190(3) would raise sufficient Constitutional doubts to warrant only prospective application.”
Next, Judge Grossman dealt with the question of whether applying the SBRA would deprive the mortgagee of “vested rights,” since the lender was on the cusp of confirming a plan.
Because the SBRA was not originally available to the debtor, Judge Grossman said he would “not penalize the Debtor because after careful analysis by Congress the law has been amended to address the needs of debtors that engage in the type of business she operates.” He noted that the lender retained “many” of the rights it originally had.
The delay occasioned by application of the SBRA, Judge Grossman said, “is not sufficiently prejudicial to [the lender], given the current economic conditions.”
The ‘50%’ Test
Next, Judge Grossman considered another eligibility requirement in Section 101(51D). At least 50% of the debt must arise “from the commercial or business activities of the debtor.” In that regard, Judge Grossman previously had held that residential mortgages are consumer debts, not commercial debts.
In the case at hand, Judge Grossman said that the debtor’s residence in the property “does not control.” Rather, the mortgage arose from the debtor’s commercial activity. He therefore ruled that the debtor fell within the definition of a small business debtor under the SBRA.
Stripping Down the Mortgage
Finally, Judge Grossman dealt with the debtor’s ability to strip down the mortgage to the value of the property under Section 1190(3). He said that subsections (A) and (B) do not bar the debtor from using the section “outright.”
Judge Grossman did not rule definitively. Instead, he scheduled a hearing to decide whether the debtor could use Section 1190(3). However, he did offer his interpretation of subsections (A) and (B).
The debtor would not be allowed to cut down the amount of the mortgage under subsection (A), he said, if the debtor used the mortgage proceeds “primarily to purchase the Debtor’s residence.” Under subsection (B), Judge Grossman said he must decide “whether the primary purpose of the mortgage was to acquire the debtor’s residence.”
When it comes to applying Section 1190(3), Judge Grossman said that an “inflexible reading of this statute would bar legitimate business owners such as the Debtor from obtaining relief under the SBRA.”
To rule on whether the debtor qualified to use Section 1190(3), Judge Grossman said he would hold a hearing to decide (1) whether the mortgage proceeds were used primarily to further the debtor’s business; (2) whether the property was an integral part of the business; (3) the degree to which the property was necessary to run the business; (4) whether customers must enter the property to use the business; and (5) whether the debtor uses employees and other businesses to run the operations.
Bankruptcy Judge Robert E. Grossman of Central Islip, N.Y., wrote the most thorough survey so far regarding a debtor’s ability to use the new Small Business Reorganization Act to propose a plan that would not be possible in an “ordinary” chapter 11.
In his April 10 opinion, Judge Grossman allowed the debtor to elect treatment under the SBRA 15 months after filing a chapter 11 reorganization that was on the verge of failure. He also laid down standards for deciding when a debtor can modify the mortgage on a property used for both residential and business purposes.
The President signed the SBRA into law on August 23. It became effective on February 19. The SBRA is codified as subchapter V in chapter 11, 11 U.S.C. §§ 1181 – 1195.
The Traditional Chapter 11 Was Failing
The debtor had purchased an historic mansion and converted the property to bed and breakfast lodging. As the local law required, she lived in the facility as her principal residence.
As a result of a previous bankruptcy, the debtor no longer had personal liability on the mortgage, which had an outstanding balance of about $1.7 million in principal and interest. The property was worth somewhere in the neighborhood of $1 million, according to the debtor.
On and off, the mortgage had been in default for years. On the verge of foreclosure, the debtor filed a chapter 11 petition in October 2018, but she did not designate herself at the time as a small business debtor.
The debtor had filed a plan proposing to reduce the mortgage to about $1 million, but Judge Grossman had ruled that her plan was nonconfirmable under Section 1123(b)(5), which precludes impairing the mortgage on property that is the debtor’s principal residence.
Meanwhile, the debtor’s exclusive right to file a plan had terminated. The mortgagee filed a plan calling for the sale of the property and had obtained the votes from unsecured creditors necessary for confirmation. The mortgagee’s plan was set for confirmation on February 26, 2020, seven days after the SBRA became effective on February 19.