A Mistake in the CARES Act on Eligibility for the SBRA Was Fixed by Congress in June

By signing the Bankruptcy Threshold Adjustment and Technical Corrections Act (BTATCA) on June 21, the President not only raised the Subchapter V debt cap back to $7.5 million, he also corrected what looks like a mistake that Congress made in 2020 when it excluded a large category of small businesses from reorganization under the Small Business Reorganization Act, or SBRA.

Responding to the pandemic on March 27, 2020, Congress laudably raised the SBRA debt cap from about $2.75 million to $7.5 million in the Coronavirus Aid, Relief and Economic Security Act, or the CARES Act. However, the CARES Act also changed the definition of a “small business debtor” eligible to file under Subchapter V.

The amendments by the CARES Act in 2020 to Sections 101(51d)(B) and 1182(1)(B) excluded companies from the SBRA if they were “affiliates” of “issuers.” Originally, the SBRA only excluded “affiliates” of reporting companies. The change was a whopper.

Generally speaking, an “issuer” under the Exchange Act of 1934 can be a small corporation that has or can have stockholders, although it is not obliged to comply with the tedious reporting requirements of the Securities and Exchange Commission. As a result, many small companies affiliated with corporations having shareholders could be excluded from the SBRA by the CARES Act.

The dramatic change, whether Congress intended it or not, was the focus of an opinion in April by Bankruptcy Judge Ernest M. Robles of Los Angeles. In re Phenomenon Marketing and Entertainment LLC, 22-10132, 2022 WL 1262001, 2022 BL 150525 (Bankr. C.D. Cal. April 28, 2022) (Phenomenon I).

Phenomenon I involved an otherwise small business debtor that happened to have two affiliates that qualified as “issuers,” but not as “reporting companies.” He rejected the argument that the change of definition was a mistake or would lead to absurd results. He said it was plausible that Congress intended to exclude small businesses that had complicated ownership structures.

So, Judge Robles relegated the debtor in Phenomenon I to “regular” chapter 11, where confirming a plan is more difficult. The road to confirmation would have been easier in Subchapter V because the debtor is not subject to the absolute priority rule. In the SBRA, the debtor can confirm a plan by devoting its projected disposable income to the payment of creditors’ claims without undergoing the rigors of cramdown when a class votes against the plan. To read the Phenomenon I opinion by Judge Robles, click here.

Judge Robles had an opening this month to set the ship aright.

In Phenomenon II, which Judge Robles handed down on August 1, the debtor filed a motion for reinstatement as a small business debtor. He traced the history of the amendments defining a “small business debtor.”

Under the CARES Act from 2020 until June 21, he said that “debtors could be excluded if they were affiliates of any corporation, even if not publicly-traded, because non-publicly-traded corporations are capable of issuing securities.”

Following the BTATCA technical amendments on June 21, “only debtors who are affiliates of publicly-traded corporations are now excluded from proceeding under Subchapter V,” Judge Robles said.

The principal creditor opposed redesignation as a small business debtor. Admitting that the debtor now fell under the definition of a small business, the creditor argued that the decision in April was a final order and that plopping the debtor back into the SBRA would violate the U.S. Constitution, as interpreted by the Supreme Court in Plaut v. Spendthrift Farm, 514 U.S. 211 (1995).

In Plaut, the high court said that a statute commanding courts to reopen final judgments violates the separation of powers. Judge Robles said that his order in April was not a final judgment of the type contemplated by Plaut. Redesignation, he said, will only apply in confirming a plan and thus “differs fundamentally from the final judgments at issue in Plaut.” Redesignation, he said, only affects “future events.”

Next, the creditor contended that the debtor was precluded from moving to redesignate by having failed to appeal the order in April. Judge Robles said there was no basis for appealing in April and that the debtor was not “circumventing the appeals process.”

Judge Robles granted the redesignation motion and allowed the debtor to proceed under Subchapter V, because the debtor was “not an affiliate of any publicly-traded corporation.” [Emphasis in original.]

Commentary

Judge Robles got it right in Phenomenon II, Mark T. Power and Joseph Orbach told ABI. They said:

Through the passage of BTATCA, Congress has clearly expressed its desire to avoid a repeat of the Court’s ruling in Phenomenon. Specifically, the amended Code no longer bars a small business from qualifying as a small business debtor simply because its affiliate is an “issuer.” Rather, Congress has now narrowed the exclusion from Subchapter V eligibility to public companies and affiliates of public companies that are subject to the Exchange Act’s reporting requirements. 

While Congress corrected a mistake, Messrs. Power and Orbach identified a loophole in the amendment big enough to drive a truck through:

Based on Congress’s amendment to § 1182(1)(B)(iii), an anomaly now exists where affiliates of foreign publicly-traded companies are facially eligible to be small business debtors because they and their parent companies are not subject to the reporting requirements under the Exchange Act despite the fact that the parent companies are publicly-traded on an overseas exchange.

Accordingly, it seems inevitable that an affiliate of a foreign public company, or even a foreign public company itself, will attempt to qualify as a small business debtor. While the $7.5 million debt limit would appear to mitigate this issue, insider debt, such as debt that a U.S. subsidiary owes to its foreign parent company, and contingent debt such as lease and contract rejection damages, are not included in the $7.5 million calculation. Consequently, even a substantial U.S. affiliate of a foreign public company may technically qualify as a small business debtor.

Messrs. Power and Orbach are partners in the New York office of Thompson Coburn Hahn & Hessen LLP. They authored an article in the ABI Journal pointing out the mistake that Congress made in defining a small business in the CARES Act. See Mark T. Power, et al., “Not so Technical: A Flaw in the CARES Act’s Correction to Small Business Debtor,” Am. Bankr. Inst. J., February 2022. To read the piece, click here.