Why Subchapter V Creditors Must Be Active at Confirmation

A recent bankruptcy court decision from the U.S. Bankruptcy Court for the Southern District of Texas discussed modification of Subchapter V plans under Section 1193 of the U.S. Bankruptcy Code.

In In re: Samurai Martial Sports Inc., the court noted that there is not much case law addressing modification of such plans under the new Subchapter V construct.

However, one only needs to analyze the plain language of relevant subchapter V statutes to determine that such modifications will rarely, if ever, benefit creditors.

Chapter 11 bankruptcy often seems like a raw deal for creditors. While a debtor is given a new lease on life, unsecured creditors may only receive pennies on the dollar. This small recovery is justified by, inter alia, the perceived value of the debtor at the time of confirmation.

But what happens if, after confirmation of a plan, a debtor wildly outperforms the projections that it set forth to a bankruptcy court in connection with plan confirmation?

One might reasonably assert that prebankruptcy creditors who received less than the entire amount of their claim under the plan should be entitled to some up that upside.

However, if the creditor is in a Subchapter V proceeding, it might be out of luck. As a result, as detailed below, it is critical for creditors to fight as much as possible during the confirmation process to ensure maximization of their return.

In 2019, Congress passed the Small Business Reorganization Act, which provided a new Subchapter V for small businesses.[1] The idea of the SBRA was to allow small businesses to reorganize in an efficient, economic and low-cost manner.

Given this intent, it is not surprising that parts of the SBRA are very debtor-friendly. Among other things, debtors obtain the following benefits in a Subchapter V case:

• Elimination of the absolute priority rule;
• No mandatory appointment of a creditors' committee;
• No mandatory requirement to file a disclosure statement;
• The exclusive right to file a plan of reorganization; and
• The ability to confirm a plan without any creditor consent.

These powerful tools have been discussed by numerous courts and commentators.[2]

In essence, the well-prepared debtor in possession can control the entire reorganization process, which culminates in the confirmation of a plan of reorganization.

The Subchapter V plan can be confirmed over creditor dissent if it does not discriminate unfairly against any impaired nonconsenting class[3] and devotes all projected disposable income toward repayment of unsecured creditors over a three or five-year period.[4]

A debtor's disposable income is defined as "the income that is received by the debtor and that is not reasonably necessary to be expended" for "the continuation, preservation, or operation of the business of the debtor," according to Title 11 of the U.S. Code, Section 1191(d).[5]

This analysis is made at the time of plan confirmation. Hence, a debtor with substandard future prospects might be able to devote a small amount of its income toward repayment of unsecured creditors.

If a debtor turns out to do even worse than expected and cannot perform under the plan, it has an option to avoid case conversion or dismissal. Specifically, a Subchapter V debtor may modify a confirmed plan post-confirmation if circumstances warrant the modification.[6]

While analysis of this provision is scant,[7] courts may refer to proposed modifications under Section 1127(b) of the Bankruptcy Code, which governs in non-Subchapter V plans.

"Collier on Bankruptcy" has stated that Section 1127(b) allows for plan modifications for "unforeseen circumstances [that] render the confirmed plan unworkable." These circumstances "cannot be the result of any unjustifiable or culpable acts or omissions from the debtor."[8]

The justification for allowing such modifications is that "debtors who undertake, in good faith, reasonable business decisions that ultimately render the plan unworkable should not automatically be precluded from modification even if the result of their decisions."[9]

Therefore, in a Subchapter V case, a debtor acting in good faith might be excused of making a poor decision, and allowed to reduce payments under a confirmed plan.

However, if the opposite facts occur, and a debtor generates additional disposable income, creditors are not allowed to apply to increase the distributions under the plan.

As stated by University of Kentucky College of Law professor Christopher G. Bradley in a scholarly article on the SBRA, "there does not appear to be any mechanism for creditors to seek modification of the plan if the debtor's fortunes change for the better."[10] Hence,

Subchapter V was specifically based on Chapters 12, which is bankruptcy for family farmers, and 13, which is bankruptcy for wage earners.[12] However, the lack of a tool for interested parties to modify a plan post-confirmation is in direct contrast with these cases and individual debtors in non-Subchapter V, Chapter 11 cases.[13]

In those types of cases, a creditor may move to modify a plan in situations in which there has been an unanticipated substantial change in the debtor's income or expenses that was not anticipated at the time of the confirmation hearing.[14]

While the substantial and unanticipated standard is not simple to satisfy, it does provide creditors and parties in interest with the opportunity to attempt to increase their distributions under a confirmed plan.

It is unclear why that standard is not in Subchapter V. Like Chapter 11 individual, 12 and 13 cases, a Subchapter V plan contemplates payments over time based on projected future income. The inability of a creditor to similarly request modification of a Subchapter V plan may not seem fair, but it is the reality in Subchapter V cases.

Unless Congress acts to modify Section 1193, only debtors have the right to propose plans and then request to modify such plans in the future.[15]

Hence, to avoid such a result, creditors must actively analyze a debtor's proposed disposable income prior to a plan confirmation hearing. Without participation, a debtor could propose a low projected disposable income based on conservative projections.

Amid uncertainty in the COVID-19 era, courts may be willing to give the debtor the benefit of the doubt as to low projections going forward.

In order to determine projected disposable income, a creditor must closely analyze all of the financial information provided by the debtor. In addition to the schedules and statement of financial affairs, a debtor submits financial information to the Office of the U.S. Trustee.

These documents include tax returns, cash flow statements, balance sheets, real property questionnaires and bank account records.

Further, a creditor should take advantage of the Section 341(a) meeting of creditors and ask pointed questions about various issues, including the future viability of the business. If a creditor disagrees with a debtor's future projections, it can object to the plan and offer expert testimony at a confirmation trial.

Subchapter V is designed to streamline small-business bankruptcies and is very debtor-friendly.

To ensure that one is not potentially swept away by a debtor's low valuations and conservative future projections, a creditor must be active and inquisitive. There is no post-confirmation possibility of altering your recovery.