Banks and other secured lenders are going to experience more losses, and larger losses, on small and mid-market loans because fewer businesses are eligible to be a “small business debtor” in bankruptcy and to use Subchapter V of Chapter 11 to reorganize their debts and get a fresh start. From March 2020 until June 21, 2024, businesses with up to $7.5 million in undisputed debt (plus an unlimited amount of disputed debt) were eligible to pursue a financial restructuring as a “small business debtor” operating under the auspices of a federal bankruptcy court.  On June 21, 2024, the definition of a small business debtor changed, and the maximum debt amount for a “small business debtor” dropped from $7.5 million to $3,024,725.  I have seen several articles and blog posts decrying this change from the perspective of debtors and bankruptcy professionals. As someone who typically looks at a bankruptcy case from a creditor’s lawyer perspective, I am concerned that this change will hurt banks and other secured lenders in the middle market. 

A small business debtor enjoys advantages under the Bankruptcy Code that are not available to companies with higher debt loads. First and foremost, the small business debtor can elect to use Subchapter V of Chapter 11, which allows owners of a small business debtor to maintain their ownership in the reorganized company without having to meet all of the requirements imposed on larger businesses, such as paying unsecured creditors in full or making a sizable infusion of new money capital that can go towards paying old debts. Small business debtors can discharge their pre-bankruptcy debts by devoting a reasonable percentage of future revenue over three to five years towards satisfying those old debts.  Once the business devotes the court-approved portion of its revenue to paying past debts for the court-approved period of time, the business can start using all of its current revenue for ongoing operations, preparing for future growth, ownership distributions, or whatever else management decides. Having that light at the end of the three-to-five-year tunnel gives small business owners a strong incentive to do the hard work required to keep their distressed businesses moving forward instead of throwing in the towel and starting over.

A small business debtor in a Subchapter V bankruptcy case is much more likely to keep operating through the bankruptcy process, to make loan payments to its secured lender, and to succeed in confirming a plan of reorganization that pays its secured lender in full, than a company that has too much debt to use Subchapter V, all else being equal.  Statistics from the U.S. Trustee’s Office show that Subchapter V cases resulted in a confirmed plan 52% of the time during FY 2020-2023, more than double the percentage of small business debtors who were able to confirm a plan outside of Subchapter V.  This statistical difference makes logical sense because a Subchapter V case is much less expensive than a regular bankruptcy case.  There are no creditors’ committee counsel fees or United States Trustee fees to pay, which can be huge savings when compared to a regular bankruptcy case. The lower burn rate of a Subchapter V case, as compared to a regular Chapter 11 case, helps a debtor have enough cash to make payments on its secured debt through the life of the case. Receiving regular payments from an operating company may allow the secured lender to avoid further downgrading the credit or devoting more of its capital to loss reserves.  That is a major boon to secured lenders, especially banks. Further, bankruptcy law allows the debtor’s attorneys and other professionals in a Subchapter V case to be paid for their work over time, including after the case is confirmed; in a regular Chapter 11 case, all professionals must be paid at plan confirmation, which is too big of a hurdle for some businesses to get over. I have seen plenty of situations where a company in bankruptcy had positive operating cash flow, but its bankruptcy case failed because the cash flow was not positive enough to cover all the expenses required to confirm a plan of reorganization in the regular Chapter 11 process.

Borrowers in distress who can see a light at the end of the tunnel are more likely to keep operating, to keep generating revenue, and to keep making payments to their secured lenders. Distressed businesses that would have qualified for a Subchapter V case before June 21, 2024, but do not qualify today, are going to have a much harder time seeing a light at the end of their tunnel. I am concerned that shrinking Subchapter V eligibility will lead to more businesses either failing in regular Chapter 11 cases or forgoing bankruptcy altogether and simply handing their lenders the keys to their collateral.  The drastic cut in the number of businesses eligible for Subchapter V will make matters worse, not better, for secured lenders.