Tuesday, August 31, 2010
Reforming Small Business Bankruptcy

Why is Chapter 11 of the Bankruptcy Code such a bad fit for small businesses?  American Bankruptcy Institute’s Resident Scholar, Juliet Moringiello, recently asked this, and other related questions, of Professor Melissa Jacoby of Univ. of North Carolina’s School of Law.  Prof. Jacoby also sits on the National Bankruptcy Conference and participates in its Small Business Working Group.  Here is a portion of Ms. Moringiello’s and Professor Jacoby’s recent Q & A, paraphrased. The entire podcast may be heard here www.podcast.abiworld.org (membership req’d).

 

Why is Chapter 11 of the Bankruptcy Code such a bad fit for small businesses?

Chapter 11 is oriented around large, publicly-held, companies. For small businesses, the process is too expensive and complex for both debtors and creditors.
The bankruptcy process assumes active creditor involvement, but in many small business bankruptcies, there is one dominant secured creditor or tax authority, who may leave little, if anything, for anyone else.  Remaining creditors aren’t interested in getting involved because the cost exceeds the benefit.

 

What is the current definition of a “small business” under the 2005 BAPCPA legislation? What revisions, if any, are under consideration?

An entity whose total liquidated debts are less than $2.0+ million. A $10 million debt limit has been proposed.

 

As calls to change the small business bankruptcy process have grown louder, what have been some of the major discussion points along the way?

The 1997 Working Group found that small businesses languish in bankruptcy because, lacking sufficient assets, there is no real way for them to reorganize. The Group suggested imposing additional deadlines to force small businesses either to file a feasible plan of reorganization, liquidate, or do something else outside of bankruptcy. Judge Ginsburg and others responded, and have taken the position that this proposal not only creates a double standard within Chapter 11, but it actually increases the burden on small business. In addition, recent research shows that judges are fairly adept at determining viability and moving non-viable entities out of Chapter 11. But not all judges are comfortable making the viability determination.

The National Bankruptcy Board has also suggested putting small business bankruptcy into Chapter 12. [Chapter 12 of the Bankruptcy Code addresses bankruptcies of family farms.]

 

Why do such a small percentage of small business bankruptcies lead to a Plan of Reorganization [POR] and emergence from bankruptcy? Most are turned into Chapter 7s [liquidation] or dismissed. Does the low rate result from the poor fit, e.g., the expense and complexity?

Actually, only a small percentage of all businesses – not just small businesses – are able to produce a feasible plan and emerge.

It is important to note that bankruptcy is first a forum for debtors and creditors, both of whom use it to force negotiations.  Second, small businesses close and re-open all the time, with or without bankruptcy, and it is not uncommon for settlements to take place outside of bankruptcy. The key is to reorganize only the viable companies and find other options for the rest.

A recent Congressional Oversight Office report strongly recommends more bank lending to small businesses, so it is very important to address the mismatch between Chapter 11 and small business bankruptcy -- while remaining mindful of the realities of small business.

 

What concepts should be considered when changing the small business bankruptcy rules?

Most important is to determine viability much earlier in the process.  Next, any changes must establish additional protections for creditors.  Suggestions have been made to assign a private trustee whose goals would be twofold:  get creditors involved who previously could not afford to get involved, and make sure that they’re treated equally once they are involved.

 

What are the proposals under consideration?

The National Bankruptcy Review done in the 1990s, and a more recent National Bankruptcy Conference put forth the idea of expanding Chapter 12 to include small businesses.

 

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In the second half of the interview, Professor Jacoby breaks down the pros and cons of 1) expanding Chapter 12 beyond family farms and fisheries, to include small businesses; and 2) amending Chapter 11 to better address the issues of small business bankruptcy.  This is found in the next blog post of Practical Turnaround Thinking.

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