By Steven D. Jerome and Emily Gildar Wagner, Snell & Wilmer
Steven D. Jerome and Emily Gildar Wagner provide a deep dive on the tools secured creditors have at their disposal in Subchapter V bankruptcy filings, specifically outlining considerations around the 1111(b) election.
In early 2020, Congress enacted new bankruptcy legislation allowing debtors to elect a novel type of bankruptcy under Chapter 11 of the U.S. Bankruptcy Code — Subchapter V — which became effective on Feb. 19, 2020, as part of the Small Business Reorganization Act of 2019.
The SBRA was designed to give small business debtors the chance to reorganize through a more budget-friendly and streamlined bankruptcy process without all of the costs and complexities of a traditional Chapter 11 filing. To qualify for a Subchapter V filing, a debtor must be: (i) engaged in commercial or business activities (excluding the primary activity of owning single asset real estate); (ii) have aggregate non-contingent, liquidated, secured and unsecured debts as of the petition date of no more than $7.5 million (excluding debts owing to affiliates and insiders); and (iii) owe debts of which 50% or more must have arisen from the commercial or business activities of the debtor. Notably, the $7.5 million debt cap was part of the Coronavirus Aid, Relief, and Economic Security Act of 2020 and is subject to revert back to $2,725,625 after March 27, 2022 unless further extended by Congress.
While Subchapter V is beneficial to small business debtors in many ways, these benefits may come at the cost of the tools secured creditors traditionally have during the Chapter 11 process.
Subchapter V Removes Traditional Creditor Protections
In a Subchapter V filing, creditors have less strategic options than in a traditional Chapter 11 filing, including, but not limited to:
A. Only a Debtor May File a Plan of Reorganization
In a traditional Chapter 11 filing, after a certain period of time or after the appointment of a Chapter 11 trustee, creditors may file their own plans. This option is particularly helpful when a debtor delays filing its plan or keeps filing unconfirmable plans. However, in a Subchapter V filing, only a debtor may file a plan, depriving creditors of a traditional Chapter 11 safeguard.
B. A Debtor Does Not Have to File a Disclosure Statement
In a traditional Chapter 11 filing, the plan proponent must prepare and file a disclosure statement, which must contain adequate information regarding the proposed plan. Creditors are given the opportunity to object to the disclosure statement to ensure there is adequate information about the creditors’ proposed treatment under the plan and whether the plan is even economically feasible. However, in a Subchapter V filing, a debtor does not have to prepare and file a separate disclosure statement. Rather, a debtor must include a brief history of the business operations of the debtor, a liquidation analysis, and projections with respect to its ability to make payments under the proposed plan. This, in essence, strips away yet another safeguard to protect creditors from potentially unfeasible plans or visionary schemes.
C. The Absolute Priority Rule Does Not Apply
Perhaps the most troubling change for creditors in a Subchapter V filing is the elimination of the absolute priority rule. In a traditional Chapter 11 filing, a dissenting class of unsecured creditors must be paid in full before any junior class may receive or retain property under the plan; this is known as the absolute priority rule. If the class of unsecured creditors votes to reject the plan, equity holders cannot receive or retain anything unless the class of unsecured creditors is paid in full.
In a Subchapter V filing, equity holders may retain ownership even over the objection of unsecured creditors who are not paid in full under the plan (and without providing new value), so long as all of the debtor’s projected disposable income for the next three to five years is applied to payments under the plan. This reverses the long-established balancing act between unsecured creditors’ recovery and equity holders’ retention and may remove unsecured creditors’ legal leverage in receiving payment, as the debtor may retain its ownership regardless.
D. A Debtor Does Not Need an Impaired Accepting Class
In a traditional Chapter 11 filing, a debtor needs the acceptance of at least one impaired class to confirm its plan. Conversely, in a Subchapter V filing, a debtor may confirm a cramdown of its plan without the approval of any class of creditors. This once again may make it easier for a debtor to confirm its plan despite creditor objections.
E. Only the Debtor May Modify the Plan of Reorganization Post-Confirmation
Unlike in a traditional Chapter 11 filing, where creditors may seek to modify the plan after confirmation under certain circumstances, in a Subchapter V filing, only a debtor may modify its plan after confirmation. So, if in a Subchapter V filing a debtor’s business significantly improves, creditors may have no recourse to request modification of the plan to seek an increase in payments. However, if a debtor’s business declines, the debtor has the ability to request modifications of the plan to decrease payments to creditors.
The 1111(b) Election: A Bankruptcy Enigma
One of the most convoluted provisions of the U.S. Bankruptcy Code is Section 1111(b) (“1111(b) election”). As a result of a reoccurring problem, Congress enacted Section 1111(b) as part of the Bankruptcy Reform Act of 1978 to redress the inequity suffered by undersecured creditors through claim bifurcation. Absent the 1111(b) election, a secured creditor whose claim exceeds the value of its collateral (i.e., is undersecured) in essence has two claims: a secured claim to the extent of the value of the collateral and an unsecured claim for the balance of the debt (i.e., the deficiency). Under this scenario, the debtor may convince the bankruptcy court to accept a lower valuation of the collateral, which would result in a lesser amount that must be paid to the secured creditor and a pennies-on-the-dollar payment on the unsecured deficiency claim. The debtor could then sell the property months or years later for much more than the previously court-determined value and realize all of the upside.
Under Section 1111(b), an undersecured creditor may protect itself from this undervaluation risk by electing alternative treatment. Instead of acquiescing to bifurcation of its secured claim, the secured creditor may waive its unsecured deficiency claim and have the total allowed amount of its claim treated as though it were fully secured by its collateral. The debtor’s plan must then provide that the secured creditor receive deferred payments totaling the full amount of its allowed claim, with the present value of the payment stream being at least the current value of the collateral.
This may be illustrated by an overly simplified hypothetical. Suppose a secured creditor is owed $6 million secured by a lien on the debtor’s office building on the petition date and the bankruptcy court determines the office building’s value is $2 million. In addition, let’s say the debtor’s plan provides for a 10% recovery to unsecured creditors and provides that the $2 million secured claim will be paid over 10 years at 10% interest, which equates to monthly payments of $26,430.15 (for a total payment amount of $3,171,617.69 over 10 years). Under the typical bifurcation process, the secured creditor would receive payments totaling $3,571,617.69 at the end of the plan as follows: $3,171,617.69 (120 monthly payments of $26,430.15) for its secured claim and $400,000 for its $4 million unsecured deficiency claim (10% times $4 million).
By contrast, assume the secured creditor makes the 1111(b) election. Now the debtor is required to pay the secured creditor $6 million (instead of $2 million) over 10 years, which equals monthly payments of $50,000. Assuming a 10% discount rate, the present value of the payment stream would be $3,783,558.17, which satisfies Section 1111(b) because the present value of the payment stream exceeds the current value of the collateral ($2 million). However, simply because this scenario satisfies the financial requirements of Section 1111(b) does not mean it is feasible and otherwise meets the other requirements for confirmation. For example, the debtor may not be able to make payments of $50,000 per month based on the rents it collects from the office building (assuming this is the debtor’s only source of revenue), whereas the debtor might be able to make the $26,430.15 monthly payments (i.e., nearly half the monthly amount) absent the 1111(b) election. Indeed, it may be impossible for the debtor to make payments under Section 1111(b) if the secured creditor makes that election, thus preventing confirmation on feasibility grounds. This leverage may be even more compelling in Subchapter Vs in which secured creditors’ other traditional strategic options are curtailed.
The Importance of the 1111(b) Election in Subchapter Vs
Given that a Subchapter V limits some of the traditional tools for secured creditors, the 1111(b) election takes on a new level of importance and may be the proverbial “nuclear weapon.”
For example, suppose a debtor files a plan that a secured creditor believes severely undervalues its collateral. The bankruptcy is primarily a two-party dispute between the debtor and the secured creditor in which the secured creditor’s loan is collateralized by (non-single asset real estate qualifying) real property. In a Subchapter V, there is no disclosure statement that the secured creditor may object to, claiming that the debtor has failed to provide adequate information about the treatment of its claim or how the plan will operate. Nor may the secured creditor file a competing plan that it believes better treats its claim. And, after the plan is confirmed, the secured creditor may not seek to modify it if the debtor’s business improves or the collateral appreciates.
So, what is in the secured creditor’s arsenal? It still has the right to make the 1111(b) election in the Subchapter V, thus potentially giving the secured creditor a powerful bargaining chip. The debtor must then offer alternative treatment under Section 1111(b) — payments in the full amount of the secured creditor’s allowed claim with such payments having a present value equal to or greater than the current value of the collateral. But sometimes that renders the debtor’s plan infeasible; realistically speaking, the debtor might not be able to pay the full amount, even over time. That then gives the secured creditor leverage in negotiating more beneficial non-Section 1111(b) treatment under the plan. If the debtor wants to avoid providing Section 1111(b) treatment, it must work with the secured creditor to offer more favorable non-Section 1111(b) terms to avoid an objection. Either way — whether it actually makes the 1111(b) election or uses it to negotiate — as a result of having the option of the 1111(b) election, the secured creditor is in a better position.
Practical Issues with the 1111(b) Election in Subchapter Vs
Given that Subchapter Vs are so new, debtors, creditors and courts are still navigating how the 1111(b) election will work in Subchapter Vs.
First, what is the deadline for a secured creditor to make the 1111(b) election in a Subchapter V? In a traditional Chapter 11, the secured creditor is to make the election “prior to the conclusion of the hearing on the disclosure statement or within such later time as the court may fix.” But there is no disclosure statement, and thus no hearing on it, in a Subchapter V. Should the deadline be prior to the filing of the plan? That would be non-sensical, as it would not give the secured creditor the ability to evaluate its options and make an informed decision. Should there be no deadline at all? That again would also prove problematic, as the secured creditor could change its position through confirmation, making it difficult to confirm the plan.
As at least one court has held, the deadline should be “the date fixed by the court;” an 1111(b) election made “before any action was taken to solicit votes on the proposed plan and before any other steps were taken in contemplation of confirmation,” is likely timely. In an abundance of caution, to the extent the bankruptcy court does not set an 1111(b) election deadline sua sponte or at the request of the debtor, the secured creditor should consider moving the bankruptcy court to fix a deadline to eliminate any uncertainty for some period after the filing of the plan. Specifically, the secured creditor should require the proposed plan to include Section 1111(b) treatment in it and run the deadline for some period of time after the filing of the proposed plan so that the secured creditor has ample time to make an informed decision about the 1111(b) election.
Second, is a secured creditor hindered by its previously filed proof of claim in making the 1111(b) election? An undersecured creditor will often list the secured portion of its claim as the value of its collateral and the unsecured portion as the deficiency. But by doing so, does the secured creditor waive the right to later make the 1111(b) election by conceding to bifurcation of its claim? The same court ruled no; a previously filed proof of claim is no bar to later making the 1111(b) election.
Thirdly, will the “inconsequential value” exception have greater meaning in a Subchapter V? Traditionally, the 1111(b) election is not applicable if the secured creditor’s interest in the property is of inconsequential value. One bankruptcy court has already ruled that the purposes and policies underlying Subchapter V may influence what constitutes inconsequential value, insinuating that this determination may differ from that in a traditional Chapter 11. In this case, where the bankruptcy court determined that the secured portion of the secured creditor’s claim was 8.2% of its total claim, it found this percentage inconsequential and denied the secured creditor the 1111(b) election.
By contrast, another bankruptcy court took the opposite approach, determining that nothing in Section 1111(b) evidences Congress’s intent to change the application of the 1111(b) election in Subchapter Vs, saying “that was for Congress to say, and Congress did not do so.” This bankruptcy court ultimately held that the value of the collateral was at least 15.6% of the secured creditor’s claim, and this was consequential enough for the secured creditor to have the right to make the 1111(b) election.
It will be interesting to see whether courts will interpret Subchapter V provisions differently or in line with traditional Chapter 11 provisions as these issues continue to evolve.
Subchapter V presents largely uncharted waters. Creditors need to be aware of their limited tools and how they may maximize the strategic options they do have, such as the 1111(b) election. Indeed, the 1111(b) election may be the secured creditor’s “nuclear weapon” in a Subchapter V. However, like many aspects of Subchapter V, the 1111(b) election’s nuances are still in flux and subject to court interpretation. Stay tuned, as courts across the country will continue to grapple with the application of the 1111(b) election in Subchapter Vs.
 The U.S. Bankruptcy Code refers to 11 U.S.C. §§ 101 et seq.
 Pub. L. No. 116-54, 133 Stat. 1079.
 11 U.S.C. § 1182(1)(A). Subject to exclusions pursuant to 11 U.S.C. § 1182(1)(B).
 Pub. L. No. 116-136, 134 Stat. 281 (effective March 27, 2020 for the period of one year); Pub. L. No. 117-5, 135 Stat. 249 (extending another year to March 27, 2022). It remains to be seen whether this will be further extended.
 11 U.S.C. § 1121(c).
 11 U.S.C. § 1189(a).
 11 U.S.C. § 1125.
 11 U.S.C. § 1181(b).
 11 U.S.C. § 1190(1).
 11 U.S.C. § 1129(b)(2)(B)(ii); see also Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 202 (1988).
 See, e.g., Bank of Am. Nat’l Tr. & Sav. Ass’n v. 203 N. LaSalle St. P’ship, 526 U.S. 434, 437 (1999). While there is something known as the new value exception to the absolute priority rule, this exception has strict restrictions. If equity contributes new value, it must be money — not future labor, management or expertise — in order for equity to retain its ownership. See Norwest Bank Worthington, 485 U.S. at 202-06.
 11 U.S.C. § 1191(b)-(c).
 11 U.S.C. § 1129(a)(10).
 11 U.S.C. § 1191(b).
 11 U.S.C. §§ 1127(e), 1181(a), 1193.
 11 U.S.C. § 506(a); see also 11 U.S.C. § 1129(b)(2)(A)(i) for the treatment of secured claims and 11 U.S.C. § 1129(b)(2)(B) for the treatment of unsecured claims.
 11 U.S.C. § 1111(b). The 1111(b) election does not apply if the secured creditor’s interest in the property is of inconsequential value or the debt is recourse and the debtor is selling the property under Section 363 or through the plan. 11 U.S.C. § 1111(b)(1)(B).
 Like most options, there are advantages and disadvantages to making the 1111(b) election, which are not discussed herein.
 In In re VP Williams Trans, LLC, the bankruptcy court ruled that that the 1111(b) election applies in a Subchapter V despite the debtor’s argument to the contrary. No. 20-10521, 2020 WL 5806507, *6 (Bankr. S.D.N.Y. Sept. 29, 2020) (slip copy).
 Rule 3014, Federal Rules of Bankruptcy Procedure.
 In re VP Williams Trans, LLC, 2020 WL 5806507, at *7.
 In re VP Williams Trans, LLC, 2020 WL 5806507, at *7.
 11 U.S.C. § 1111(b)(1)(B).
 In re Body Transit, 619 B.R. 816, 837-38 (Bankr. E.D. Pa. 2020).
 In re Body Transit, 619 B.R. at 838.
 In re VP Williams Trans, LLC, 2020 WL 5806507, at *6.
 In re VP Williams Trans, LLC, 2020 WL 5806507, at *6.