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Strategic Bankruptcy: How Subchapter V of Chapter 11 Might Save Your Independent Restaurant

If you are following the restaurant trade news media (as you should), you will note a spate of Chapter 11 bankruptcy filings among national restaurant chains during the pandemic. If you associate bankruptcy with financial failure, you might find this news as somber yet unsurprising evidence of the magnitude of our economic crisis.

Relatively recent changes in federal law provide advantages of Chapter 11 bankruptcy that were previously out of reach for many small businesses due to the complexity and expense. In light of the current pandemic economy, now might be a good time for restaurants to explore "Subchapter V" as a means to get breathing room from creditors and reorganize their businesses to move forward on more solid ground. In this article, Joseph Pack, a bankruptcy legal expert and founder of Pack Law, explains why.

Many people have a basic understanding of bankruptcy, if only from late-night television commercials by consumer bankruptcy lawyers. People file for bankruptcy if they can't pay their debts. And for individuals, bankruptcy provides debt relief; however, with the risk of making it difficult to obtain credit in the future. Few individuals are proud of filing for any type of bankruptcy.

In the realm of commercial bankruptcy, Chapter 11 bankruptcy is often a business strategy, not a proverbial white flag raised in defeat. Companies often emerge from Chapter 11 bankruptcy stronger and more able to compete in changing economic and market conditions.

Chapter 11 is popular as a legal mechanism to allow companies in financial duress to reorganize their finance, marketing, and operations without the pressure of creditors bearing down on them to be paid. In Chapter 11 bankruptcy cases, the court oversees a manageable plan to repay, in part if not in whole, those to whom the company owes money. Chapter 11 also allows business interests to go forward, preserving and creating jobs and contribution to the economy.

So what does this mean to you, the independent restauranteur? For many years, Chapter 11 bankruptcy was impractical for small businesses because of its expense and complexity. Small businesses in financial tailspins were often limited to filing Chapter 7 bankruptcy -- also known as liquidation -- and shuttering their operations. Adding injury to insult, in some cases, as explained below, it could place owners and directors at risk of personal liability.

The barrier to entry for Chapter 11, with its unique protections and opportunities, for small businesses was not lost on attorneys, judges, and -- most importantly -- legislators, giving rise to The Small Business Reorganization Act (SBRA) of 2019. The SBRA created Subchapter V (as in the Roman numeral "5") of Chapter 11 of the Bankruptcy Code.

In the realm of commercial bankruptcy, Chapter 11 bankruptcy is often a business strategy, not a proverbial white flag raised in defeat. Companies often emerge from Chapter 11 bankruptcy stronger and more able to compete in changing economic and market conditions.

The SBRA became effective on February 19, 2020. And the timing possibly could not have been better, in light of the pandemic and its effect on small businesses, including those in the restaurant industry.

Joseph Pack is a New York and Florida restructuring attorney and also is an annual guest law professor in the advanced bankruptcy courses at the University of Florida Levin College of Law and the University of Miami School of Law. He just founded Pack Law with offices in Miami and Fort Lauderdale, pivoting from a career working with the most prestigious, large law firms, where he gained tremendous experience representing creditors and large, publicly traded companies in hotly contested, complex bankruptcy matters.

With experience representing stakeholders on both sides of the fence, Pack, also as a licensed Certified Public Accountant, is uniquely qualified to help guide small businesses through this new Subchapter V of the Bankruptcy Code. In this article, he discusses how Subchapter V works and why independent restaurant businesses might consider filing for Subchapter V bankruptcy sooner than later, even if they are managing to keep their doors open during this difficult period.

'It's a Huge Deal'

Pack emphasizes how important Subchapter V is to small business. "It's a huge deal," he says of the relatively new changes to Chapter 11. To appreciate its value, you need some background on commercial bankruptcy in general, says Pack.

"Let's start the discussion with an overview of Chapter 7," he says, referring to the section of the bankruptcy code in which a business liquidates all its assets and the court assigns a trustee to divide them among creditors who receive a share based on their relationship to the company. For example, so-called "secured" creditors -- those who issued credit backed by collateral -- are first in line. If shuttering one's business is not miserable enough, "directors of these businesses can be subject to litigation in state court for breach of fiduciary duty," says Pack, who also represents creditors that bring these claims.

While bankruptcy is federal law and under the jurisdiction of the federal court system, state laws "may require owners and directors of corporations to maximize value to all stakeholders, including creditors and investors," explains Pack. If they have engaged in what the courts view as self-dealing, such as transferring assets to third parties to hide them from creditors and shareholders, they could be the subject of litigation. "There is never a clean breakup in Chapter 7 bankruptcy," he adds.

In a Chapter 11 case, however, "There is a contract," says Pack. "As a debtor, you can negotiate with creditors. And it's a clean breakup between you and your discharged debt;" in other words, the debt the business is no longer required to pay back. "You, as the owner or director of the business, are not going to be defending lawsuits because you've likely negotiated those away as part of the plan," he says. In short, it is a more orderly approach to bankruptcy; that is, for the most part.

An Automatic Stay and Then Some

As in all bankruptcy filings, in a Chapter 11 case, an "automatic stay" takes place immediately. An automatic stay is a provision in United States bankruptcy law that temporarily prevents creditors, collections agencies, government entities, and individuals from pursuing debtors for amounts owed. In essence, it is the debtor's "breathing spell" to take a break from responding to or fending off creditors.

Unlike a Chapter 7 bankruptcy filing, in a Chapter 11, the debtor still remains in possession of the business. The court-assigned federal bankruptcy trustee cannot seize assets. "You are still running the business," says Pack, adding, "management stays in control." At that point, he explains, "you have a certain amount of time to create a plan" reorganization to keep its business alive and pay creditors over time, but the Bankruptcy Court will provide ample time if that effort is going in the right direction.

The federal bankruptcy trustee typically appoints a creditor committee of unsecured creditors who hold the largest or otherwise most important representative unsecured claims against the debtor. The unsecured creditors' committee simplifies the process by appointing a single, usually large creditor, to speak for the entire committee. Under traditional Chapter 11 bankruptcy, a big downside for the debtor is the expense. "The debtor has to pay its own, and the unsecured creditors' legal fees," says Pack.

Approval of a proposed plan is referred to as "confirmation." Ultimately, confirmation of a proposed plan rests with the bankruptcy court. To confirm a Chapter 11 plan, the bankruptcy court must find that it meets numerous requirements, which go beyond the scope of this article.

Traditional Chapter 11 is not only expensive, but it can be complicated and time-consuming. The court wants to see a detailed valuation of all assets to satisfy "a best-interest test," says Pack, explaining it requires creditors receive at least as much under the Chapter 11 plan as they would if the debtor's case were converted to Chapter 7 liquidation.

Pack explains not all creditors or classes of unsecured creditors will like the plan. They might tell the court the plan will hurt their interest if it is confirmed. In those cases, the court can exercise its "cram down" power. In that case, the court "crams the plan down the throat of all the dissenting creditors so long as there is one impaired class voting in favor of the plan," says Pack.

Enter Subchapter V

As Pack explains, Chapter 11 can be valuable to large companies that can afford the expense and time to wade through the process. Until Subchapter V, it was not feasible for small businesses.

It has many of the benefits of traditional Chapter 11. Unlike a Chapter 7 case, the Subchapter V trustee can't sell the debtor's assets and does not take control over the debtor's business. The trustee is more like an advisor and handler, facilitating the development of a consensual reorganization plan, appearing at major hearings, and ensuring that the debtor makes timely payments under the plan. In a Subchapter V case, however, the debtor pays the trustee and its own legal fees, but not the legal fees of the creditors.

Also, as noted above, in Subchapter V, the process moves much more quickly than traditional Chapter 11 cases. The Court will hold a status conference within 60 days from the filing. At least 14 days before that conference, the debtor must report in writing on the efforts made, and to be made, to get a consensual plan. The debtor must file its plan of reorganization within 90 days from the filing.

Another advantage to Subchapter V is only the debtor may file a plan, unlike a traditional Chapter 11 case, in which creditors or other parties in interest may file a competing plan. And Subchapter V helps debtors dodge protracted disputes. In a traditional Chapter 11 case, the debtor has to file and distribute a disclosure statement to provide creditors with information regarding the plan so that they can decide if they like the plan or not.

Creditors often dispute the adequacy of the disclosure statement, which leads to delays and court battles. Subchapter V does not require a disclosure statement. Subchapter V also doesn't require an impaired class of creditors voting in favor of the case for "cram down." Generally speaking, the debtor can cram down the plan on all creditors, merely demonstrating the creditors are better off through the Subchapter V plan as compared to Chapter 7 liquidation.

One of the reasons independent restaurants should be doing this now is their payments are based on projections. Because of the current financial distress experienced by independent operators, it is likely their projections for the ability to repay creditors are as conservative as they will ever be.

Bear in mind, there is also no creditors' committee in a Subchapter V case, which saves the debtor's time and money. A downside of filing Chapter 11 is if the debtor business can't make payments as specified in its plan, the case converts to Chapter 7; however, there are numerous upsides in the current economy.

So, Why Should Restaurants Consider Filing for Subchapter V Now?

A Subchapter V debtor doesn't need to file a disclosure statement, only the aforementioned plan, which includes a summarized history of the business operations, a liquidation analysis, and projections demonstrating the ability of the debtor to make the proposed plan payments.

As Pack explains, the requirement in the plan to provide projections demonstrating the ability of the debtor to make proposed plan payments is why many independent restaurants should consider filing Chapter 11 now.

"One of the reasons independent restaurants should be doing this now is their payments are based on projections," says Pack. Because of the current financial distress experienced by independent operators, it is likely their projections for ability to repay creditors are as conservative as they will ever be.

Pack believes the cost of a meeting with a bankruptcy attorney who understands Subchapter V is well worth the prospect of reducing debt obligations to unsecured creditors, which includes landlords and repayment of CARES Act loans to the Small Business Administration. Subchapter V includes an option for the debtor to contribute all "projected disposable income" to making plan payments for three to five years. Projected disposable income is everything after expenses to maintain and support the debtor and expenditures necessary for business operations.

No Shame and Potential Gain

Pack has found even some highly successful and sophisticated business owners perceive filing bankruptcy as a badge of dishonor. On a personal level, it is understandable, he says, but unnecessary, and even detrimental to a person's or their business' long-term success in an economy with difficulties people understand the business owners did not create.

Filing bankruptcy under Subchapter V might not be the best route for your business. Nevertheless, Pack believes it is well worth the time and money to explore it with an attorney who understands how it works and how to leverage it for your restaurant.