A small business debtor who elects to proceed under subchapter V of chapter 11[1] has the same rights and powers to sell property under 11 U.S.C. § 363 as a trustee or a debtor in possession in a larger case.[2] But it remains to be seen whether subchapter V will be used by debtors who intend to sell substantially all of their assets in a § 363 sale, or to confirm liquidating plans. A key benefit of subchapter V is that it allows a small business owner to retain its equity by eliminating the absolute priority rule, or a requirement that the owner contribute new value to retain its equity. Therefore, it seems more likely that subchapter V cases will be used by small business owners who prefer to reorganize with a three-to-five-year payment plan as an alternative to liquidation.
While it is too early to know for sure,[3] sales in subchapter V cases will more likely be used by debtors to “downsize,” rather than liquidate, and therefore will involve discrete assets that the debtor finds burdensome or unnecessary. In this article, we will discuss the provisions of subchapter V that discourage all-asset sales and promote reorganization, the types of sales that are likely to occur in subchapter V cases, and issues that may arise from these sales.
Subchapter V Was Not Designed for All-Asset Sales
In creating subchapter V of chapter 11, the drafters of the Small Business Reorganization Act of 2019[4] followed many of the recommendations of the Commission to Study the Reform of Chapter 11.[5] Among the themes and concerns raised by the Commission were “a perceived increase in the number and speed of asset sales under section 363 of the Bankruptcy Code,” a “perceived decrease in stand-alone reorganizations,” and a general consensus that chapter 11 generally no longer works for small or medium-sized enterprises.[6] Of particular concern was the increase in all-asset sales, especially when expedited where it is difficult to know if the sales maximize value.[7] In addition, the commission noted that “the market for small companies is virtually nonexistent” because most small companies have no value without their owner-managers.[8] And even if a market existed, often the owner-managers of small businesses are intent on maintaining ownership of a business they may have built from the ground up.[9]
Subchapter V Promotes Reorganization over Going-Concern Sales
In order to address the commission’s concerns, subchapter V includes provisions that facilitate reorganizations with existing ownership and management. First, subchapter V eliminates the absolute priority rule of 11 U.S.C. § 1129(b)(2).[10] As a result, pre-petition owners can retain their equity even if creditors are not paid in full, thus obviating the need to infuse new capital to potentially satisfy the rule. Consequently, the owners have an incentive not to sell because of the potential profits after the subchapter V plan is completed.
Equally important, a subchapter V plan must include projections of future income and provide that all of the debtor’s projected disposable income will be applied to payments under the plan for a three-to-five-year period.[11] In fact, 11 U.S.C. §§ 1190 and 1191 do not include options to pay creditors a lump sum from proceeds of an all-asset sale. Obviously, a three-to-five-year payment plan would require that the debtor retain sufficient assets to operate the business and generate disposable income. If a debtor in a case under subchapter V were to sell substantially all assets, the debtor almost certainly would not be able to satisfy the requirements for plan confirmation under 11 U.S.C. § 1191. In short, subchapter V is intended to be rehabilitative, not a means of orderly liquidation.
Sales Will Be of Discrete Assets
Because subchapter V is designed to promote rehabilitation rather than liquidation, a debtor intent on selling its business as a going-concern is unlikely to elect it. Still, sales of discrete assets may be important to reduce ongoing expenses for secured debt, eliminate burdensome assets, and generate cash to fund operations. For example, a debtor may be able to sell real estate and downsize its facilities to reduce future overhead costs. Or, a debtor may be able to sell excess equipment or inventory that is subject to a blanket lien, cram down the lender’s secured claim to the fair market value of the remaining equipment and inventory, and thereby have lower monthly payments for the secured lender’s claim. In many ways, such sales will conjure the early days of the Code when all-asset sales were circumspect and case law required stricter proof of exigency.[12]
Notably, sales of discrete assets often are less expensive and less complicated than a sale of a business as a going-concern, which usually requires the employment of investment bankers to analyze the value of the business and contact the limited universe of potential buyers with the appropriate industry experience. Real property and equipment, on the other hand, often can be sold with just an appraisal and a broker or an auctioneer. In other words, sales of assets in subchapter V cases will likely resemble sales in cases under chapter 7 or 12 (but without the option of discharging capital gains taxes under 11 U.S.C. § 1232).
If a subchapter V debtor does sell substantially all assets, it would likely be only after giving up on reorganization. Most small businesses, though, would not be able to afford dual-track efforts to reorganize and sell substantially all assets. By the time a subchapter V debtor gives up on reorganization, it would likely be too late to engage investment bankers or to meaningfully market the business as a going-concern. There is also the risk that a subchapter V debtor would exhaust its cash collateral or DIP financing by the time that the debtor comes to the conclusion that reorganization is not possible, which would impair the debtor’s ability to continue operating until a sale closes. Therefore, with the possible exception of sales of underperforming divisions that have stand-alone viability, such sales are likely to be liquidation sales of distinct real and personal property, rather than going-concern sales of an enterprise.
Conclusion
Although a subchapter V debtor has the same rights and powers to sell property as other chapter 11 debtors, subchapter V was designed for reorganization and was not designed to facilitate sales of substantially all assets. Therefore, sales under subchapter V of chapter 11 are likely to consist of discrete assets and will probably resemble sales that occur in cases under chapters 7 and 12, or in the early days of the Code.
[1] 11 U.S.C. §§ 1181-95.
[2] 11 U.S.C. § 1184.
[3] As of the time of this writing, the authors are unaware of any subchapter V debtors who have sold substantially all assets.
[4] Pub. L. No. 116-54.
[6] Id. at 15-16.
[7] Id. at 84 (“[S]ales of all or substantially all of a debtor’s assets on an expedited basis, particularly early in the chapter 11 case, can raise concerns about (a) the proper valuation and marketing of assets, (b) whether other restructuring alternatives were fully explored, and (c) whether the court, the U.S. Trustee, and stakeholders have sufficient information and time to review and comment on the proposed transaction.”).
[8] Id. at 285, n.1034.
[9] Id. at 285, n.1034 (“[B]ecause of the absolute priority rule, the owner-managers common in small businesses may be reluctant to file a petition before the company is in dire condition because in bankruptcy, they risk losing their financial interests in the business.”).
[10] 11 U.S.C. § 1181.
[11] 11 U.S.C. §§ 1190(a)(1)(C) and 1191(c).
[12] See, e.g., In re Lionel Corp., 722 F.2d 1063 (2d Cir. 1983).