Little did congressional authors know how many small businesses might soon need the revisions to Chapter 11 bankruptcy law when they passed the Small Business Reorganization Act (SBRA) last summer.
The thrust of the new law, which took effect in February, is to make it easier and more affordable for small-business people to reorganize their debt and hang on to their operations. That includes property owners and managers, although there are some significant limitations, especially in the case of single asset real estate (SARE) debtors.
While America’s business community waits and watches to see if a wave of bankruptcies, foreclosures, repossessions -- you name it -- materializes as deferrals, forbearances, and other concessions expire, now is a good time to find out what this might mean to real estate investors.
To find out more, Millionacres turned to Robert W. Dremluk, a partner in the New York offices of Culhane Meadows. His practice focuses on real estate, bankruptcy, and financial restructuring, and here he shares some basics about the Chapter 11 changes:
What are the SBRA bankruptcy law changes, in a nutshell?
The SBRA created a new Subchapter V of Chapter 11 and eliminated a number of sections of Chapter 11 that had made a traditional reorganization case unduly burdensome and costly for a small business and individual businesspeople.
The biggest structural change under SBRA is the ability of a debtor to reorganize without creditor approval under what is described as a so-called modified cramdown plan.
In the past, a debtor was only able to proceed with a Chapter 11 plan if at least one class of impaired creditors voted to accept its plan. Now, subject to certain conditions, a debtor can confirm a plan so long as its disposable income is used to fund that plan over a period of three to five years
Interestingly, there is no requirement that a small business debtor remain engaged in the commercial or business activity after filing for bankruptcy, but the debtor must show that at least 50% of its pre-filing debts arose from such activities.
Overall, how are these new rules important to real estate investors?
While not specifically directed toward real estate, Subchapter V creates an opportunity for entities with smaller amounts of debt to restructure debt and reorganize their business -- which will often involve a real estate component.
Real estate owners, lenders, and investors should be aware of how this streamlined bankruptcy process may affect their strategies in dealing with distressed businesses in protecting their rights or identifying investment opportunities.
One potential benefit of Subchapter V for real estate owners, lenders, and investors is that the debtor may have more funds available to pay real estate obligations, thus preserving the value of the property.
Overall, how are these new rules important to property managers, commercial and residential?
Again, being informed about how SBRA and Subchapter V works is important for all parties, including commercial and residential property managers.
For example, one unique aspect of Subchapter V is that an individual who operates an eligible small business may modify a mortgage secured by a residence if the underlying loan was made for commercial purposes.
In other words, if the individual mortgaged his or her residence and used the loan proceeds in connection with its business activity, then that mortgage may be modified. This is a change from existing law that generally prohibits modification of mortgages secured by a principal residence.
But there’s an important category of debtor left out of the new rules, correct?
Yes, SARE debtors (single-asset real estate debtors) are specifically ineligible for relief under Subchapter V. A SARE debtor is a debtor who derives substantially all of its gross income from the operation of a single real property.
The term single asset real estate has generated a substantial amount of debate and litigation.
One frequently litigated issue in SARE cases is whether the debtor’s property is a single property or a project, such as properties linked together in some fashion in a common plan or scheme.
A second heavily litigated issue is whether the debtor’s real estate generates a substantial portion of its gross income from the property. In other words, is such income derived from sale, rental, or operation of real property.
However, if substantial revenues are generated from activities separate and apart from the sale or lease of the real property, then SARE would not apply. Or, if the debtor generates income ancillary to owning real property, then the other business, if significant, is not considered incidental to owning the property, and SARE does not apply.
Examples where SARE does not apply include hotels, golf courses, marinas, and timberland.
There's a different cap in there now, from $2.5 million to $7.5 million. What is that about?
The debt ceiling for a small business to file under Subchapter V was recently increased temporarily (March 27, 2020 to March 28, 2021) to $7.5 million under the CARES Act.
This debt ceiling increase expands access to bankruptcy relief to thousands of small businesses. Whether and how this will benefit real estate owners, lenders, or investors remains to be seen, but more entities will be eligible for Subchapter V relief.
An interesting issue has arisen with respect to whether a Subchapter V debtor can access funds through the Small Business Administration (SBA) Paycheck Protection Program (PPP) to pay for real estate-related obligations.
This issue is being litigated in several courts. Some courts have barred the SBA from disapproving PPP loan applications and funding, and other courts have found that SBA guidelines prohibit debtors from either applying for or receiving a PPP loan.