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For some time now, Congress has been mainly known for gridlock and uncivil debate.  But there have been many moments when Congress has come together in a bipartisan fashion to find solutions to long-standing problems. One of those moments occurred three years ago when members of both parties in both the House and Senate got together to pass the Small Business Reorganization Act (SBRA). Then a funny thing happened after the expansive new law was enacted – it worked exactly as intended.   

Background 

The SBRA was designed to address widely perceived problems that small businesses encountered when trying to reorganize under chapter 11 of the Bankruptcy Code. There was a developing consensus that chapter 11 was too costly and slow for businesses with modest assets which could not afford the financial drain and distraction of drawn-out bankruptcy processes. As a result, businesses that might be saved were dismantled and jobs unnecessarily lost. 

The new law added a new voluntary subchapter V within chapter 11 for businesses holding less than $2.7 million in debt (adjusted annually for inflation). As an alternative to navigating the complex chapter 11 process, subchapter V provided streamlined procedures and tighter deadlines for debtors to develop a plan to rehabilitate the ailing business. The key substantive change under SBRA was the elimination of the "absolute priority rule” whereby the owners of the debtor-business had to pay creditors in full or lose their equity and control. This was a major downside for closely held and family businesses that lacked bankruptcy sophistication and did not want to unduly risk losing the enterprise they had worked a lifetime to build.  

Among many other important changes, the new law also required the United States Trustee to appoint private trustees with a mandate to help ensure the filing of accurate financial information and to facilitate the filing of a consensual plan of reorganization. The trustee also is expected to identify businesses that cannot successfully reorganize and help move them to liquidation sooner before all the assets are dissipated. 

There were major challenges in implementing the law. Not the least amongst those challenges was the USTP finding about 200 new trustees with business acumen. Although many existing trustees appointed under other chapters also were appointed under subchapter V, it was important to select businesspeople who would focus on finances, rather than lawyers who might focus on litigation. In addition, there was a lot of initial concern that debtors’ counsel would be reluctant to give up partial control of the case to an independent trustee whose mandate was to assist both debtors and creditors in finding a swift business solution. 

The SBRA became effective in February 2020, just a month before much of the country shut down due to COVID. In an effort to assist more businesses facing economic hardships caused by the pandemic, Congress quickly expanded SBRA to cover businesses with up to $7.5 million in debt.  That change increased the number of SBRA debtors by one-third. The higher debt limits were temporary for one year and later extended until June 2024.   

Metrics of Success     

The early results of SBRA were favorable and those trends have continued.  Here are some of the key metrics of success:

• Three out of every four small business bankruptcy debtors choose to proceed under the expedited subchapter V process. This shows the popularity of the alternative among both small businesses and their bankruptcy counsel. To date about one-third of all chapter 11 cases are small businesses. 
• Subchapter V small businesses confirm a reorganization plan at almost twice the historical rate for small businesses (56 percent vs. 31 percent.) In addition, more than 70 percent of the confirmations are consensual plans without creditor opposition. (There are no compilations of historical data on consensual plans in non-SBRA cases.)
• Subchapter V cases are dismissed at less than one-half the historical rate for small businesses (25 percent vs. 53 percent.) This suggests that subchapter V trustees are successfully helping smaller companies stay in business.
• Subchapter V cases are resolved more quickly and spend less time in bankruptcy. Subchapter V debtors confirm plans about 40 percent faster than the historical speed for small businesses (6.4 months vs. 10.8 months). Similarly, cases are dismissed more than 20 percent faster than the historical average (4.7 months vs. 6 months).   

A few caveats are in order. The law is still fairly new so trends may not hold.  Creditors also may want to crunch their internal numbers to compare their rate of recovery on debts under SBRA and the old system. Importantly, ultimate outcomes – such as whether companies that reorganize under SBRA complete their plan payments and remain viable over the long-term -- will require the passage of more time before they can be measured. 

Conclusion       

Government often-times seems broken, but sometimes it still works. All available objective data point to success so far for SBRA achieving the objectives Congress set when it passed the new law. Creditors may want to study their own internal results.  Congress will need to evaluate longer-term experience before deciding whether to extend the higher debt limits when the current SBRA expansion expires in two years.  

Commentary provided by Clifford J. White, Managing Director – Bankruptcy Compliance for AIS.

Bankruptcy filings have been at historic lows since the beginning of the COVID pandemic in 2020. But deteriorating national economic conditions and recent chapter 13 filing data suggest that bankruptcy increases may be on the horizon. If history is any guide, then more scrutiny of creditors’ compliance with bankruptcy and consumer protection laws and rules can be expected as well. All this may make it a good time for financial institutions and other creditors to review their bankruptcy processes to reduce the risk they will come under the regulatory microscope. 

Historical Bankruptcy Filing Rates

Although predicting bankruptcy filing rates may be more hazardous than at any time in recent memory, it is worth noting that filings have been gyrating over many years. For example, 40 years ago bankruptcy filings stood at 380,000 cases. Last year, they reached about 414,000, or 18 percent above the low-water mark of the past five decades. But charting filing numbers between those years is a lot like drawing a rollercoaster.         

The graph below (Figure 1) shows bankruptcy filing numbers for the past 20 years.  In the 1990s, bankruptcy filings climbed above million. As the chart shows, they continued to climb until they exceeded two million cases in 2005. That number was somewhat artificial, however, because Congress sought to reduce the precipitous increase in filings by passing the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which imposed a means test and made other significant changes in the law. Many lawyers tried to beat the effective date of the 2005 amendments by urging their clients to file sooner. Debtors did exactly that. Of course, that led to a sharp drop in filings the next year. Filings then began to rise to more normalized levels.          

The next blip on the chart occurs in about 2008-2010 during the Great Recession when external economic conditions drove filings skyward. After that, filings leveled off and changed very little from about 2016-2019. Then the COVID pandemic hit.  Many of us predicted that the pandemic would cause a large increase in filings. I was wrong. Instead, as Figure 1 shows, the numbers dropped – by a lot. In retrospect that is not surprising because the amount of government cash and other assistance, including foreclosure and eviction moratoria, were unprecedented. But there are new signs that filing patterns are changing.

Figure 1

Chapter 13 Filing Increases    

Figure 2 charts the past 12 months of chapter 13 filings. Insofar as chapter 13 is designed for individuals with a regular income, many of whom have fallen behind on secured debt payments and still want to save their home or car, one might expect home foreclosure and eviction moratoria to influence filing rates strongly. Figure 1 suggests exactly that. The federal eviction moratoria generally ended last July. That is where our chart begins. As the trend line shows, chapter 13 file rates are up significantly over the past 12 months. Comparing January to June rates alone, the 2022 filing rates are 32 percent above the previous year.          

In light of other economic conditions, this increase may forebode future increases as well, at least in chapter 13.

Figure 2

Deteriorating Economic Conditions    

In addition to the expiration of government aid, which eventually will have an impact on many economically vulnerable consumers who were able to delay the day of financial reckoning, macroeconomic conditions are unfavorable. For the first time since the late 1970s through 1982, we are seeing high inflation, rising interest rates, and perhaps slowing economic growth. In early June of this year, the World Bank (along with many economic mavens) warned of "stagflation.” And Chase CEO Jamie Dimon said there is an economic "hurricane” heading our way. Since those prognostications were uttered, national economic data have not painted a brighter picture.   

Reduce Regulatory Risk  

The last time we faced a sharp economic downturn, federal regulators enhanced their scrutiny of bankruptcy and other creditor practices. Among things, this culminated in a $25 billion national mortgage settlement and many other multi-million-dollar bankruptcy settlements pertaining to the accuracy of proofs of claim for secured and unsecured debt alike. Perhaps more expensive in the long-run than remediation to consumer debtors, regulatory relief sometimes entailed injunctive relief (e.g., monitors to review internal creditor practices) and severe reputational damage.With filings still relatively low, and regulatory actions concomitantly lower, this may be a good time for creditors to perform a check-up on their bankruptcy compliance systems to make sure they can withstand future regulatory scrutiny.   

Conclusion         

All reputable creditors want to treat consumer fairly and in compliance with law. But even the best of systems for handling distressed accounts need a check-up every now and again to be sure faulty practices did not seep in. Now may be a good time for a regulatory refresh before Jamie Dimons’s predicted "hurricane” hits consumers and creditors alike.

To download the June Insight Report, click here.

Commentary provided by Clifford J. White, Managing Director – Bankruptcy Compliance for AIS.