Blog Posts
Bankruptcy
NOW WHAT? The Future of the Small Business Bankruptcy Act
We have all seen and heard of the mega-bankruptcy cases in the news, whether for reasonable economic causes (Forever 21, JC Penneys, GNC) or for attempted strategic advantage (J&J Talc Litigation; Boys Scouts Sexual Abuse claims, or various Religious Dioceses). The costs and expense to the business entities seeking federal bankruptcy protection has become astronomical. The legal and consulting fees are in the millions of dollars each month. The concept of seeking bankruptcy relief was clearly becoming cost-prohibitive for most businesses. Just prior to the unimaginable pandemic, Congress sought to remedy the problem by creating and adopting the Small Business Reorganization Act (“SBRA”). This Act became effective February 19, 2020. The purpose was to make bankruptcy more efficient and affordable to the real-world business community. The Act sought to provide these efficiencies for businesses with less than $2,725,625 in total debt. Literally, 30 days later, we are all in the throes of the modern COVID-19 Pandemic. At the time, no bankruptcy practitioner was truly aware of how SBRA would actually work; however, Congress, with perhaps some fear of small business collapse as a result of global economic shutdowns, adopted at lightning speed the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”). This Act was adopted and signed by the President on March 27, 2020- just over a month following SBRA’s effective date. The most critical provision of the CARES Act was the increase of the eligibility threshold for qualifying for a Small Business Bankruptcy from the established $2,725,625 claim amount to the increased sum of $7,500,000. This increase opened up the SBRA benefits to a significant amount of business. Why is this so important? Simply stated- the cost-effective benefits of Debtors in a Small Business Bankruptcy are significant. First, there is no obligation for a Small Business debtor to pay Quarterly Fees to the U.S. Trustee System. In a normal chapter 11 bankruptcy case, a company in chapter 11 is obligated to pay fees to assist in funding government oversight of the bankruptcy process by assessing a fee based on the total dollar amount of disbursements made by the bankruptcy company while it remains in a chapter 11 proceeding. Yes, the company, in addition to paying its regular bills and operation expenses, must pay an additional “fee” just from being in Bankruptcy. For the non-mega case- this obligation alone could, and has, caused the bankruptcy effort to fail. They did not file bankruptcy to be obligated to pay more for normal business operations. SBRA excuses Small Business debtors from paying this fee. A second major benefit is that no creditors committee is permitted to be formed in a Small Business Bankruptcy. In the normal chapter 11 case, quite often, the larger unsecured creditors are permitted to band together and form an official recognized committee to be authorized to negotiate their best treatment from the debtor. Once established, the creditors’ committee is permitted to hire professionals such as a lawyer and accountant to represent the committee. The costs associated with these professional fees, however, is required to be paid by the Debtor. Again, a cost that can torpedo many businesses in their quest to reorganize. SBRA eliminates this exposure by prohibiting creditors committees. The third significant benefit of the Small Business Bankruptcy is the elimination of the application of the absolute priority rule. This rule found under Section 1129 of the Bankruptcy Code provides that a debtor’s plan of reorganization cannot be approved by the bankruptcy court unless it provides that all creditors who hold a higher prioritized claim are first paid in full before a subordinated priority class of claims can retain any interest in the reorganized company. Since unsecured creditors claims hold a higher priority for payment than business owners, a business owner under a regular chapter 11 cannot retain their ownership interest unless some exception can be established. Since most small businesses are owned and controlled often by a few family members, eliminating this requirement goes a long way in promoting the salvation of America’s small businesses. So clearly, there are great benefits under SBRA which gives a majority of small businesses a better chance at survival. The CARES Act extended this benefit to even a wider and necessary breadth of business. Unfortunately- the CARES Act extension of this increased eligibility number was only intended to be temporary. Under the original enactment, the increase was intended to revert to the original lesser eligibility amount in one year- on March 27, 2021. With the COVID-19 pandemic remaining in flux by the early Spring of 2021, U.S. Senator Richard Durbin, a Republican from Illinois, introduced S.473 entitled the COVID-19 Bankruptcy Relief Extension Act of 2021 on February 25, 2021. The Act sought to further extend the increased eligibility for qualifying for a small business bankruptcy for an additional year until March 27, 2022. Remarkably, this legislation again moved through both Houses of Congress and was eventually signed by the President- actually after March 27, 2021- but who is watching. This brings us to present day, and the first question asked- NOW WHAT? See on March 14, 2022, Senator Durbin again introduced legislation in the Senate- S.3823, which without saying much of anything, looks to simply eliminate Section 1113 of the CARES Act. Why is this important- because that section is the section which establishes the sunset provision for the eligibility increase. If this section was eliminated, the increased eligibility threshold of $7,500,000 would become permanent. This certainly is well supported by the Debtor Bankruptcy Bar and the American Bankruptcy Institute. Regretfully the world again gets in the way of this important legislative amendment. On March 14, 2022, S. 3823 was referred to the Senate Judiciary Committee. Everyone was hoping for prompt consideration by Judiciary and then forwarding the Legislation to the full Senate for approval. The Bill is was optimistically anticipated before the expiration on March 27, 2022, as mandated under the current Section 1113. Unfortunately, however, last week, the Senate Judiciary got tied up with a certain Judiciary Hearing questioning some Judge looking to be approved to sit on the Supreme Court. The Committee did not have the time to consider S. 3823. The legislation was not adopted in time, and as a result, on Monday, March 28, 2022, eligibility to qualify for a small business bankruptcy reverted to the lesser $2,725,625. Due to inflationary provisions of the bankruptcy code, on April 1, 2022, the qualification number will be adjusted to $3,024,725, however, this number is a far cry from $7,500,000. Many viable businesses have been left out in the cold. The story- and hope is not all lost. Despite S.3823 remaining before the Senate Judiciary Committee when the higher threshold lapsed, there remains overwhelming support for this very necessary change for small business bankruptcy qualification. With the anticipated significant future increases in lending costs and a further demand on small business, demands of business will become even more pressing. Work remains to be done, but the increase in the qualification amount is favored and will hopefully be reinstated soon. On April 7, 2022, ten days after the expiration of the law, the Senate unanimously approved the legislation with some minor revisions and sent the adopted bill to the House. According to the Congressional website, the Bill was received by the House of Representatives on April 11, 2022, and held at the desk. What happens between now and then is anyone’s guess. For questions about the Small Business Bankruptcy Act, contact Paul J. Winterhalter at pwinterhalter@offitkurman.com.
April 28, 2022
Bankruptcy
Lenders Beware
WHEN IS A LENDER CROSSING THE LINE AND ENTERING LENDER LIABILITY WONDERLAND? A 2022 decision out of a bankruptcy court in Texas reminded lenders that an overly aggressive approach to a borrower can result in lender liability[1] and substantial damages. In this case, brought by a Chapter 7 trustee, the bankruptcy court concluded that the lender destroyed the debtor’s enterprise value and future as a going concern and ultimately drove the debtor out of business. The Court found that for the lender’s actions, the debtor would not have failed as a going concern and would not have had to file bankruptcy. As a result, the Court awarded $16,966,928 in damages for breach of contract and breach of the duty of good faith and fair dealing, fraudulent misrepresentation, contractual and business interference, and willful violation of the automatic stay. The lender unsuccessfully tried to argue that the debtor was dead on arrival. [1] As the bankruptcy court put it, “[l]ender liability” is a broad umbrella term often used to describe various theories through which a borrower (or its trustee in bankruptcy) seeks to impose liability (or a remedy of some sort) against a former lender in a lending relationship that has soured.” THE STORY BEHIND THE AWARD Bailey Tool & Manufacturing Company and its subsidiaries and affiliates (“Bailey”) was the debtor/borrower in this tragic story. Republic Business Credit, LLC (“Republic”) was the lender. Before filing bankruptcy, Bailey and Republic entered into a factoring arrangement and an asset-based loan facility in February 2015. Republic performed substantial diligence in late 2014 and early 2015 before entering into the agreements. During the due diligence process, Republic had identified several issues, including unpaid ad valorem taxes, stretched accounts payable, and a major customer (the Department of Defense) that paid on a milestone rather than progressive billing basis. Despite these issues, the underwriter viewed the proposed transaction as a “strong deal” and approved it. Four months after entering into the agreements, Republic refused to advance funds as expected, declared default and made payments to itself from Bailey’s lockbox under the factoring agreement to pay down the ABL (Asset Based Lending) facility. The Court found that Republic took complete and total control of Bailey’s cash. It controlled not only the collections through the lockbox and all disbursements too. All funds advanced from July 2015 forward were sent directly to vendors selected by Republic vendors and a payroll company for the payroll of employees selected by Republic. The Court held that the lender’s handling of disbursement was inconsistent with the parties’ agreements—specifically, the Factoring Agreements contemplated that Republic would “pay to Seller [Bailey] an Advance.” In September 2015, Republic stopped funding altogether. Republic also became involved in replacing management and otherwise micromanaging the Debtor. It forced the Debtor’s Chief Executive Officer to give the Republic a lien on his exempt homestead. THE DECISION In a meticulous 145-page decision, the Court analyzed the Republic’s conduct, including and highlighting numerous internal lender email communications produced in discovery and presented during the trial. The Court adopted the bankruptcy trustee’s theory of the case, i.e. that the lender: (i) refused to advance funds in good faith and in the manner promised almost immediately after the agreements were signed taking a stance that the businesses were in an “over-advanced” position, which was not a defined concept in the agreements and was problematic in light of several weeks of due diligence and awareness regarding certain slow-paying accounts and inventory status; (ii) charged fees, expenses, penalties and other items against “reserves” (contributing to the alleged “over-advanced” position), without any transparency; (iii) exercised excessive control over the businesses by controlling what vendors, employees, and expenses got paid and insisting on direct payments to them by the factoring company rather than funding to the businesses as contemplated by the underlying agreements (i.e., the argument being that this was an improper exertion of control; there were no amendments of documents or forbearance agreements to justify deviating from the underlying agreements). WHAT ACTION TO AVOID AS A LENDER This decision can now serve as a roadmap for borrowers to establish lender liability. In summary, the factors considered by the Court include: Taking over the business function and exercising business judgment – Without the requisite knowledge and experience, Republic approved payments to certain vendors and materials suppliers, reordered the sequence in which different products at Bailey were manufactured, and changed the manufacturing priorities from keeping long-term customers, to doing “quick-turn” projects; Controlling the workforce at Bailey through controlling the payroll and ordering who got paid and who did not and what types or classifications of employees could get paid; Directing vendors of Bailey to pay Republic instead of Bailey under the threat of litigation, destroying the goodwill that Bailey had built up with these vendors; Lack of transparency and misrepresentations as to why: (i) why it considered Bailey to be in default, (ii) the status of funds availability or lack thereof, (iii) application of funds collected and charging numerous fees and expenses. The conduct of the lender, in this case, appears egregious. Still, it is a reminder for lenders to closely review with counsel contractual remedies and exercise caution in implementing these remedies.
March 31, 2022
