Daniel M. Pereira

This is the second part of a two-part series on bankruptcy options for subsidiary or affiliate winddowns. Part one provides an introduction and discusses the benefits and drawbacks of Chapter 7 of the U.S. Bankruptcy Code. Part two discusses the benefits and drawbacks of Subchapter V.

Benefits and Drawbacks of Subchapter V
The intent of Chapter 11 of the U.S. Bankruptcy Code’s Subchapter V is to provide a streamlined, cost-efficient process by which small businesses can reorganize under Chapter 11 of the Bankruptcy Code. Subchapter V allows small businesses to utilize the benefits of a Chapter 11 filing without expending substantial funds. Although Subchapter V was enacted ostensibly to allow small businesses to inexpensively and quickly reorganize, it may also be used to sell the debtor’s assets and winddown operations. To qualify for Subchapter V, a debtor must be engaged in commercial or business activities (per the courts, a low bar), at least 50% of the debtor’s debt must be business-related, and the debtor must have less than $7.5 million in non-contingent secured and unsecured debts.

The primary benefit of Subchapter V bankruptcy as compared to Chapter 7 bankruptcy is that the ownership or management remains in control of the debtor pursuant to Section 1107 of the Bankruptcy Code. Moreover, a Subchapter V is substantially more cost-effective than a traditional Chapter 11 case for all of the aforementioned reasons. The primary downside, as compared to Chapter 7, is that it will be more expensive since the debtor remains in control and must administer the estate, arrange and obtain approval of the sale process, incur the cost of preparing a proposed plan, negotiate with creditors, and pay the fees of a Subchapter V trustee.

Subchapter V modifies or does away with many of the requirements and/or hurdles present in most Chapter 11 cases with the intent to effectuate a less costly and quicker process. Among other things, in a Subchapter V, there is typically no creditors’ committee to drive up costs. In a Subchapter V, as in most Chapter 11 bankruptcies, existing ownership or management continues to operate its business and a traditional bankruptcy trustee is not appointed to take control of and manage the debtor’s business. Instead, a Subchapter V trustee is appointed. However, the Subchapter V trustee does not have the same powers as the Chapter 7 or Chapter 11 trustee. Instead, they act as something akin to a mediator, facilitating negotiations between the debtor and its creditors to attempt to achieve a fully consensual Subchapter V plan.

Although in some cases the Subchapter V trustee’s role may be expanded, the Subchapter V trustee does not have the same broad powers as the Chapter 7 or Chapter 11 trustee to investigate causes of action, operate the debtor’s business, receive estate property, review and object to claims, and propose a Chapter 11 plan. The Subchapter V trustee’s fees must be paid out of the bankruptcy estate.

Subchapter V confers significant benefits upon debtors. For example, the Subchapter V debtor is not required to file a disclosure statement in connection with its plan, which can greatly reduce the expense of a Chapter 11 filing. Subchapter V also does away with the absolute priority rule, meaning that ownership may retain its equity interests in the debtor even where senior creditors are not paid in full. Rather than pay all unsecured creditors in full before equity is permitted to retain its interest, a Subchapter V debtor need only propose a plan that pays unsecured creditors all projected “disposable income” over three to five years. This is a substantial benefit for reorganizing small businesses although less so for liquidating debtors.

Further, unlike traditional Chapter 11 bankruptcies, creditors cannot propose competing plans, so the debtor remains fully in control of the plan process. Finally, although one of the fundamental goals of a Subchapter V bankruptcy is to obtain a fully consensual plan, the Subchapter V debtor can confirm the Subchapter V plan without obtaining the consent of any creditors. In contrast, in a typical Chapter 11 bankruptcy, where the debtor proposes to impair creditors’ rights, the debtor must obtain the approval of at least one impaired class of creditors.

However, in exchange for such benefits, Subchapter V debtors are expected to move quickly and, among other things, must propose a plan within 90 days of filing. Missing the plan deadline can result in dismissal or forced conversion to a Chapter 7 bankruptcy. Because of these tight deadlines, ownership should not put an entity into Subchapter V without a preformulated plan and strategy already in hand so that the bankruptcy court can establish and approve a sale process early in the case.

Generally, the sale process would be similar to the sale process described in the first part of our series regarding Chapter 7, but the debtor remains in control rather than a bankruptcy trustee. The debtor will typically market its assets for sale, identify an initial bidder, obtain the bankruptcy court’s approval of the bidding procedures, and then obtain the bankruptcy court’s approval to sell the assets to the winning bidder. Along the way, interested parties have an opportunity to object to the process and the sale.

In Subchapter V, the debtor’s efforts to sell its assets to an insider may face increased scrutiny from creditors, interest holders and the bankruptcy court since the debtor remains in control of the process. However, so long as the court approves the sale, the court finds that the process is fair, the debtor maximizes value for the bankruptcy estate, and the sale is made in good faith, ownership, management and any buyer of the assets should largely be insulated from exposure to any post-sale claims that they breached their fiduciary duties or that there was a fraudulent transfer. Ultimately, although the debtor remains in control of the process, it remains an open, court-supervised sale process that presents ample opportunity for interested parties to object. As such, any exposure arising from a sale of the debtor’s assets should be de minimis.

It should be noted that just as in a Chapter 7 case, the debtor-in-possession in a Chapter 11 case has the power and, indeed, an obligation to investigate potential claims against third parties, including potential claims against directors and officers for prepetition breaches of fiduciary duties. However, in the absence of a creditors’ committee, a creditor is much less likely to challenge such a decision. Nevertheless, a particularly invested or active creditor could elect to challenge that decision and make the process more costly and drawn out.

Consult with Bankruptcy Counsel
Any parent or management considering how to most effectively dissolve or wind down an affiliate or subsidiary, particularly when considering whether or how to first transfer valuable assets out of the dissolving entity, should consult with bankruptcy counsel for a fuller evaluation of whether a Chapter 7 or Subchapter V bankruptcy makes sense. Although a non-bankruptcy dissolution or winddown may make sense for some entities, there are circumstances in which a Chapter 7 or Subchapter V bankruptcy will be more desirable, particularly where liabilities exceed assets but there nevertheless are valuable assets to be administered.