This article originally appeared in the February issue of the American Bankruptcy Institute Journal, the essential resource for today's busy insolvency professional.
The Small Business Reorganization Act of 2019 (SBRA) added subchapter V to chapter 11. In defining the eligibility for subchapter V, Congress amended the Bankruptcy Code’s definition of a “small business debtor” to exclude specifically corporations that are subject to the reporting requirements under the Securities Exchange Act of 1934, essentially making publicly traded companies ineligible for subchapter V. Congress further constricted this definition through the Coronavirus Aid, Relief and Economic Security (CARES) Act to also exclude debtors that are affiliates of public companies from subchapter V eligibility. However, rather than refer to any debtor that is an affiliate of a corporation that is “subject to the reporting requirements” in the Exchange Act, the CARES Act instead used different language, excluding any debtor that is an affiliate of an “issuer” as defined in the Exchange Act, without any reference to the reporting requirements.
Given the expansive definition of an “issuer” in the Exchange Act, the amended CARES Act language, as drafted, now facially excludes debtors from qualifying for subchapter V simply by virtue of being an affiliate of an “issuer” of a security, even if such issuer is not a public company. As a result, practitioners face a daunting challenge of having to convince a bankruptcy court that their otherwise-qualified debtor should be eligible to file under subchapter V even though one of its major, nonpublic shareholders technically qualifies as an “issuer.” Conforming the limitation of small-business-debtor eligibility in § 1182(1)(B)(iii) with respect to an affiliate to match the limitation contained in § 1182(1)(B)(ii) with respect to the debtor itself would eliminate the uncertainties created by the usage of the term “issuer” and provide clarity to practitioners and the courts, while simultaneously furthering the original congressional intent of the SBRA to exclude public companies or their affiliates from qualifying for subchapter V.
Small businesses, typically family-owned or startups, account for most of the chapter 11 business cases that are filed. To address the lack of monitoring by creditors whose claims are often not large enough to warrant active participation in small business cases, Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), which required heightened scrutiny and streamlining the reorganization process. Notwithstanding BAPCPA, Congress determined in 2019 that “small business chapter 11 cases continue to encounter difficulty in successfully reorganizing.” Consequently, Congress enacted the SBRA to amend chapter 11 to streamline the bankruptcy process by which small business debtors would reorganize and rehabilitate their financial affairs.
Prior to the CARES Act amendment to the SBRA, § 1182(1) defined “debtor” as a small business debtor. Section 101(51D)(A) defined a “small business debtor” as a person engaged in commercial or business activities (including any affiliate that is also a person engaged in commercial or business activities and excluding single-asset real estate debtors) with aggregate noncontingent liquidated debts of not more than $2,725,625.9 The SBRA specifically excluded from the definition any corporation that “(I) is subject to the reporting requirements under section 13 or 15(d) of the Exchange Act of 1934 ...; and (II) is an affiliate of a debtor.”
Section 1113 of the CARES Act temporarily increased the eligibility threshold to file under subchapter V to businesses with less than $7.5 million of debt. This relief was later extended through March 2022 by the COVID-19 Bankruptcy Relief Extension Act of 2021. However, the CARES Act also amended the definition of a “small business debtor” in § 101(51D)(B)(iii) to preclude from subchapter V “any debtor that is an affiliate of an issuer” as defined in the Exchange Act.
Looking at the pre-amended SBRA’s definition of a “small business debtor,” it is evident that Congress intended to exclude from subchapter V eligibility public companies, including affiliates. However, by utilizing the phrase “any debtor that is an affiliate of an issuer” as opposed to the phrase “subject to the reporting requirements under the Exchange Act,” Congress has potentially excluded businesses that would otherwise qualify to be subchapter V debtors, and has made the process of determining whether a business qualifies to be a subchapter V debtor unnecessarily complex.
One must apply a two-prong test to analyze a debtor’s eligibility for subchapter V under § 1182(1)(B)(iii): (1) whether there exists an affiliate relationship between the proposed debtor and its closely-related entity; and (2) whether the applicable entity is an “issuer” under the Exchange Act. Once that test has been satisfied, the next inquiry is to determine whether the entity is subject to the reporting requirements under §§ 13 or 15(d) of the Exchange Act to see whether the exclusion under § 1182(1)(B)(ii) applies.
The bankruptcy court’s analysis of the first prong in In re Serendipity Labs Inc. is insightful. The issue before the court was whether § 1182(1)(B)(iii) precluded Serendipity Labs (the debtor) from electing to proceed under subchapter V because it was an affiliate of Steelcase Inc., and Steelcase was an “issuer” under the Exchange Act. To rule on its eligibility, the court had to determine (1) whether the debtor was an affiliate of Steelcase, and (2) whether Steelcase was an “issuer.”
While the debtor argued that Steelcase was not an affiliate because it owned only 6.51 percent of the debtor’s shares authorized to vote on the debtor’s bankruptcy filing, the debtor’s secured lender argued that the debtor was an affiliate because Steelcase owned more than 27 percent of the debtor’s outstanding voting securities. The court rejected the debtor’s argument and concluded that mere 20 percent ownership of the debtor’s voting securities mandates affiliate status, stating that it was irrelevant what percentage of the voting securities held by Steelcase were authorized to vote on the debtor’s bankruptcy filing.
In that case, the court also did not have a problem finding that Steelcase was an “issuer,” and therefore concluded that the debtor was ineligible to proceed under subchapter V because it was an affiliate of Steelcase. The Exchange Act broadly defines “issuer” to mean “any person who issues or proposes to issue any security.” This definition is extremely broad when read together with “security,” as defined in the Exchange Act. The implication of Serendipity Labs is that a small business that would otherwise qualify to be a subchapter V debtor will be ineligible — even if the issuer is not a public company.
Reporting Requirements Under §§ 13 or 15(d) of the Exchange Act
Section 12(a) of the Exchange Act makes it unlawful for any broker or dealer to effect any transaction in any security (other than an exempted security) on a national securities exchange unless a registration has been made under the Exchange Act. An issuer with total assets exceeding $10 million and a class of shares held of record by either 2,000 persons or 500 persons who are not accredited investors at the end of any fiscal year must register such shares with the Securities and Exchange Commission (SEC) within 120 days after the end of that fiscal year. There are a number of exemptions to the registration requirements under § 12(a), including securities of certain nonprofit, charitable issuers and certain “cooperative associations” as defined in the Agricultural Market Act. However, a company with registered securities under § 12 is subject to the reporting requirements under § 13 of the Exchange Act with the SEC.
Every issuer of a security registered under § 12 of the Exchange Act is required to file with the SEC certain periodic disclosures and reports, including annual reports (Form 10-K), quarterly reports (Form 10-Q) and current reports (Form 8-K). Issuers that have registered securities under the Securities Act of 1933 (offerings of securities for public sale) must also file certain current and periodic reports as required under § 13 of the Exchange Act, even if they do not list their securities on an exchange.
In general, all securities offered in the U.S. must be registered with the SEC or must qualify for an exemption from the registration requirements. This requirement under § 15(d) of the Exchange Act often caused problems for small issuers with less than 300 security-holders of record if the drop below the 300 did not occur at the beginning of a fiscal year. SEC Rule 12h-3 now suspends the reporting requirements for these issuers.
Having the definition of a “small business debtor” reference “issuer” without any limitation is problematic, though, because any potential debtor that has an affiliate relationship with an entity issuing a security could technically be precluded from filing a subchapter V case, even if such issuer is not an issuer subject to the Exchange Act reporting requirements.
What Is a “Security?
This problem is further complicated by the reality that not every instrument is a security. Transactions or instruments that are atypical must be examined on a case-by-case basis to determine whether they fall within the purview of the federal securities laws. It is difficult to imagine that Congress intended to exclude from subchapter V eligibility companies or their affiliates whose securities are not publicly traded or otherwise exempt from the registration requirements. The amendment to the definition of a “small business debtor” has seemingly created complexities contrary to the SBRA’s purpose to enable small businesses to reorganize more efficiently and cost-effectively.
While some instruments are easily recognized to be securities (e.g., common stock), some categories of instruments or transactions require intensive analyses to determine whether they are securities subject to the federal securities laws. “Security” is broadly defined by the Exchange Act to include “any note, stock ... certificate of interest or participation in any profit-sharing agreement ... investment contract.” Recognizing the virtually limitless scope of countless schemes devised by those using investors’ money to generate profits, Congress determined that the best way to protect investors was to define the term “security” in sufficiently broad and general terms. Although the literal definition of “security” is broad, courts have rejected a literal interpretation.
To alleviate the unintended complexities and potential over-exclusion of debtors from subchapter V eligibility created by usage of the term “issuer,” Congress should amend § 1182(1)(B)(iii) to read “any debtor that is an affiliate subject to the reporting requirements under section 13 or 15(d) of the Exchange Act of 1934 (15 U.S.C. 78m, 78o(d)).” Removing the phrase “of an issuer” will simplify the analysis for determining a debtor’s eligibility under § 1182(1)(B)(iii) by eliminating the need to convince the court that an otherwise qualified debtor that is an affiliate of an “issuer” under the Exchange Act should still be eligible to file under subchapter V. This proposed change would seemingly align with Congress’s intent in enacting the SBRA, as well as with the express language of § 1182(1)(B)(ii), which specifically excludes corporations subject to the reporting requirements under the Exchange Act.
Joseph Orbach and Mark Power are members of the Firm's Financial Restructuring & Bankruptcy Practice Group.
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