The Restructuring Report

Amid the throes of the COVID-19 pandemic, industries across the U.S. economy have been impacted in unprecedented ways. Small businesses in the service industry, including restaurants, continue to experience significant disruption in their operations and correspondingly their ability to generate cash flow and profits. Since the outbreak of the virus, restaurants have experienced the forced closure of their dining rooms due to government orders, leaving only those that could operate at reduced capacity through take-out or delivery services. Consequently, U.S. restaurant sales decreased an eye-popping 78 percent in April 2020, with the industry losing an estimated $30 billion in March 2020 alone. This downturn greatly affects service industry debtors, as restaurants traditionally operate with extremely thin profit margins (most restaurants operate at three to five percent) and other unique financial situations. As a result, more than eight million restaurant employees were laid off or furloughed so far during the pandemic.

With no complete end of the pandemic in sight, service industry debtors, who may need to look to the bankruptcy courts in order to survive and reorganize, have been given a critical tool in operating with a continuing and post-COVID-19 world: the recently (and fortuitously) adopted and implemented Subchapter V of Chapter 11 of the Bankruptcy code (the Small Business Reorganization Act). Subchapter V institutes significant changes for those qualifying debtors in dealing with their existing debt. However, for service industry debtors, Subchapter V includes the following particularly helpful changes to Chapter 11 of the Bankruptcy Code that may be a coronavirus lifeline for those businesses that qualify.

Administrative Claims

One of the largest expenses for service industry debtors is the cost of rent for their brick-and-mortar locations. Under a traditional Chapter 11 case, even when designated a small business debtor, these claims would need to be paid on the plan’s effective date or in the ordinary course of business. However, under Subchapter V, a service industry debtor is now allowed to stretch payment of administrative expense claims, including its outstanding post-petition rent payments, over the term of its Chapter 11 plan. This change prevents the need for the small business debtor to gather enough cash as of the plan’s effective date and instead allows it to helpfully spread this potentially large expense over three to five years when business will have hopefully improved.

Absolute Priority

The owners of service industry debtors used to face the potentially disincentivizing obstacle to filing for Chapter 11 relief of the potential loss of equity ownership under the absolute priority rule. Subchapter V helpfully eliminates the absolute priority rule, allowing owners of service industry debtors qualifying as small business debtors to retain their ownership or equity interests in their business even if their Chapter 11 plans do not pay their creditors in full or provide new equity to the business, so long as the plan does not discriminate unfairly, and is fair and equitable, with respect to each class of claims that is impaired under and has not accepted the plan. This change may ultimately provide the owners of the small business the incentive they need to continue to operate—providing jobs and services to the community—instead of cutting their losses by shuttering their businesses doors.

Cost Saving

With the procedural requirements of traditional Chapter 11 filings, service industry debtors used to face significant costs related to the administration of the bankruptcy case. Subchapter V, however, streamlines the bankruptcy process. Of note, Subchapter V eliminates the requirement of an unsecured creditors committee, sets a condensed and strict schedule for life of the bankruptcy case, and removes the need to file and get the approval of a disclosure statement. Together, these changes should lower the costs of filing and completing a Chapter 11 case for qualifying service industry debtors who find themselves cash-strapped from depressed business due to COVID-19, consequently making a reorganization an option where originally only liquidation made sense.

Debt Limit Raised

Initially Subchapter V’s debt ceiling of $2,725,625 may have disqualified some service industry debtors from filing under the act. However, as part of the CARES Act, the U.S. government recently increased the debt limit for Small Business Reorganization Act cases to $7.5 million. While this increase will sunset after one year, this temporary change opens the eligibility for a Subchapter V bankruptcy to significantly more service industry debtors that may have otherwise not qualified for this beneficial new tool.

It remains unclear how effective these changes will be in helping qualifying small business debtors reorganize due to its novelty. Nevertheless, the above-described features of Subchapter V let service industry debtors deal with some of the most significant obstacles facing their reorganization under a traditional Chapter 11 case, while providing them and their owners with the incentive to file a Subchapter V case. With such benefits in hand, qualifying service industry debtors have the opportunity not only to survive the COVID-19 pandemic, but to later thrive.

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