CARES Act Offers Additional Leverage for Small Businesses through Small Business Reorganization Act

The detrimental effect of COVID-19 on businesses throughout the United States has been broad, deep and abrupt. In response, business owners are reassessing cash flow projections to determine the longer-term viability of their businesses. Congress has also responded by including in the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act a provision that increases—from about $2.7 million to $7.5 million—the debt limit under the Small Business Reorganization Act (“SBRA”) for companies that determine chapter 11 relief is necessary. Affiliate or insider debt is excluded from the debt limit. The increase is effective for a period of one year only. 

A business decision to file for chapter 11 is a nuanced one, and this update does not address the circumstances that warrant consideration of bankruptcy protection. However, Congress’ decision to increase the debt limit for small businesses to access the SBRA provisions of chapter 11 makes the SBRA available to a greater number of small businesses, and does so at a time when businesses around the country are exploring ways to conserve cash, restructure some of their ongoing liabilities, and manage litigation claims.

The SBRA has been effective only as of February 20, 2020, so it is very much untested in our bankruptcy courts. However, it was designed to make business reorganization in chapter 11 more efficient and less expensive, while also giving small-business owners greater control of their business operations during the case and more flexibility in proposing and confirming a plan of reorganization.

In a traditional chapter 11 case, shareholders and members cannot retain their equity interests unless either (i) the company can confirm a consensual plan of reorganization or (ii) shareholders/members contribute new value on account of retaining their equity interests. This rule is known as the absolute priority rule, and often deters small-business owners from seeking chapter 11 relief because failure to satisfy this rule often results in a change of control or liquidation. A company that is eligible for SBRA treatment under chapter 11, however, can confirm a plan of reorganization that keeps the owners in control of the reorganized business even if the business cannot pay creditors in full, so long as the company’s plan of reorganization is feasible and fair and equitable to the company’s creditor constituencies over a period of three to five years.

More generally, chapter 11 allows a company to freeze outstanding prepetition contractual obligations for a period of time to give its owners and managers a breathing spell to propose a restructuring. Depending on the nature of the company’s obligations, a chapter 11 filing may assist management’s ability to conserve cash for a period of time, especially if the company has a viable business model, patient supply chain, and loyal customer base. So while chapter 11 should not be a company’s first choice to address the ramifications of COVID-19, we anticipate that over the coming months many companies will be comparing chapter 11 reorganization in connection with out-of-court workouts with their creditors and key stakeholders.