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The Federal Government has announced its largest insolvency reform package in over 30 years, which includes a simplified formal debt restructuring process for eligible small businesses.
The centerpiece of the reforms is the adoption of a US-style "debtor in possession" restructuring model, which closely mirrors the recently enacted small business restructuring provisions of subchapter V of the US Bankruptcy Code.
Given the similarities between the two regimes, the Australian market can look to the United States for guidance in navigating these restructuring reforms. In this article, our US restructuring team shares some initial insights from the US experience of subchapter V.
Overview of Australia’s Proposed Reforms and Subchapter V
The insolvency reform package announced on 24 September 2020 (the "Proposed Reforms")1 seeks to reposition Australia’s insolvency regime to facilitate the successful restructuring of the significant number of small-to-medium sized businesses ("SMEs") that are expected to require turnaround solutions when Australia’s temporary insolvency relief measures expire at the end of the year.2
While large companies will continue to be regulated by Australia’s existing insolvency laws, businesses with liabilities of less than AUD 1 million will be eligible for the "simplified debt restructuring process" (the "SDRP") that will be enacted by the Proposed Reforms.
Under the SDRP, directors will continue to operate the business instead of ceding control to an external administrator. However, the SME will be required to engage a "Small Business Restructuring Practitioner" who will oversee the development of a restructuring plan, certify that plan before it is voted on by creditors, and manage distributions to creditors. If the plan is not approved by the requisite majority of creditors (i.e., 50% by value), the SDRP process will end and the directors may choose to enter another insolvency process, such as external administration or a streamlined liquidation.3
The Proposed Reforms bear striking similarity to the small business restructuring procedures provided by subchapter V ("Subchapter V") of chapter 11 of the US Bankruptcy Code.4 Subchapter V was enacted in August 2019 and took effect in February 2020.5 It represents the culmination of more than 40 years of law reform attempts, pilot programs and judicial case management protocols, all dedicated to maximising value in SME restructurings.6 Given its long history of reform in this space and its recent practical experience of Subchapter V, the US is likely to provide useful guidance for the Australian market as further details of the Proposed Reforms are released and the reforms take effect. Although preliminary, our initial observations based on the Reform Fact Sheet are below.
In response to the economic impact of COVID 19 on US businesses, the US Congress increased Subchapter V’s debt eligibility threshold to more than 10 times above the proposed Australian SDRP level. It remains to be seen whether the SDRP debt ceiling will allow enough business to efficiently access restructuring relief in the COVID-19 environment
Eligibility for the SDRP will be more restrictive than its US counterpart. As an initial matter, only incorporated Australian businesses will be able to access relief under the SDRP. By contrast, any business, including individuals operating unincorporated businesses, are eligible to file for Subchapter V, so long as 50% of their liabilities constitute business debt.7
Moreover, the SDRP’s proposed debt ceiling is ten times lower than Subchapter V. Only those Australian businesses with liabilities under AUD $1m will be eligible to opt into the SDRP regime, which represents 76% of businesses subject to insolvency today.8 Subchapter V initially had a debt ceiling of USD $2.7m (approx. AUD $3.8m), capturing a comparable percentage of historical chapter 11 cases.9 However, Congress has increased Subchapter V’s eligibility threshold to USD $7.5m (approx. AUD $10.6m) in response the projected increased demand precipitated by the COVID-19 pandemic.10 Additionally, loans from affiliates or insiders do not count towards Subchapter V’s debt cap,11 which may be significant in the current economic climate. It is unclear whether similar exclusions will apply to the SDRP.
As Australia’s temporary insolvency relief measures expire and the extent of the effect of COVID-19 on Australian businesses becomes apparent ⸺ including the extent to which businesses have incurred trade and other debt to continue operating ⸺ there may be cause to make the SDRP more widely available.
The SDRP is not a wholesale adoption of all the powers afforded to a debtor-in-possession under Subchapter V, and contemplates maintaining customary Australian carve-outs for secured lenders. However, certain features of Subchapter V, which are not presently contemplated by the SDRP, may also be beneficial for Australian SMEs ⸺ particularly the ability to restructure certain director guarantees, reject burdensome contracts, and pay administrative expenses over the life of the plan
The Proposed Reforms expressly contemplate that commencement of the SDRP will trigger certain of the same debtor protections that normally apply in an external administration. These include a moratorium against enforcement actions by unsecured and certain secured creditors, and a stay on the enforcement of ipso facto clauses, which allow creditors to terminate contracts by reason of the occurrence of certain prescribed events, including the commencement of a restructuring process.
The SDRP has been tailored to the Australian restructuring landscape, and does not adopt the US DIP financing regime. Additionally, the Proposed Reforms contemplate "no changes to the rights of secured creditors."12 Accordingly, it is anticipated that secured creditors with security over substantially the whole of the SME’s assets will still be able to enforce their collateral during the SDRP process and will not be bound by a plan unless they consent to it.13
Moreover, the Proposed Reforms currently do not contemplate giving Australian SME’s a US-style contract rejection power.14 The US has seen an increase in debtors taking advantage of their rights in bankruptcy to reject burdensome contracts that are no longer market under the "new normal." An orderly contract rejection process may support Australian SMEs to adjust to a post-COVID world and increase the number of successful restructurings.
While the Proposed Reforms contemplate that director guarantees will not be enforceable for the duration of the SDRP moratorium, it is unclear whether such personal guarantee obligations will be eligible for restructuring pursuant to the plan. Given the important role that director guarantees play in the SME sector, allowing for the restructuring pursuant to an SDRP plan of business loans secured against a director’s personal residence (as permitted under Subchapter V)15 would give directors an added incentive to make use of the new legislation.
Finally, while the SDRP will require the debtor to pay all employee entitlements before a plan is put to creditors, Subchapter V provides debtors with more flexibility to pay administrative expenses over the life of the plan.16 Accordingly, the ability of an SDRP debtor to confirm a plan may depend on its ability to secure new liquidity during the 20 business day period.
Although they are debtor-in-possession models, both Subchapter V and the SDRP still require an independent insolvency practitioner to act as the umpire. Appropriately defining the scope of the Australian Small Business Restructuring Practitioner’s functions will be essential to balancing the interests of creditors and debtors
Efficiently restructuring SMEs is a delicate balancing act. On the one hand, the erosion of equity value creates an incentive for the SME’s proprietors to take greater risks to re-capture the value of their investment, potentially to the detriment of the SME’s creditors. Indeed, in some cases, existing management have contributed to the cause of the enterprise’s financial distress in the first place. In this regard, the US Congress has recognized that SME debtors-in-possession require heightened scrutiny.17 On the other hand, too much red tape and the administrative expenses normally attendant to restructurings, which larger enterprises can generally support, are often untenable for many small businesses.18
Subchapter V seeks to address this concern by expediting SME restructurings and reducing costs through the replacement of the supervisory function performed by a creditors’ committee with the oversight provided by an independent trustee.19 However, whereas the SDRP is anticipated to be an out-of-court process, the bankruptcy court still plays an important role in Subchapter V cases. For example, Subchapter V debtors are required to seek approval from the bankruptcy court to use, sell, or lease property of the estate and incur debt outside of the ordinary course of business.20 Given the likely much more limited role of Australian courts in overseeing the SDRP process, the Small Business Restructuring Practitioner will be crucial for protecting creditors’ interests and ensuring appropriate supervision of the director’s management decisions. It remains to be seen what specific duties will be imposed on the Practitioner, and whether the Practitioner will have any oversight powers beyond the ability "to stop the process where misconduct is identified."21 Striking the right balance between debtor agility, directors’ duties, and Practitioner supervision of the process will be essential to the success of the Proposed Reforms.
Time is of the essence in SME restructurings, but some leniency in plan related deadlines may be warranted to maximise plan approval prospects
Australian SMEs will be afforded only 20 business days to propose a restructuring plan to their creditors, with creditors permitted to vote on the plan over a 15 business day period. By contrast, US SMEs have 90 days to propose a plan, with the possibility of further extensions.22 This timeframe is based on established judicial case management practices developed to "fast-track" SME bankruptcy cases, while setting an achievable schedule.23 Additionally, under Subchapter V there is no time limit for plan confirmation,24 which seeks to avoid creditors waiting out the debtor to leverage their position, rather than working collaboratively to agree a restructuring plan.
While it is essential in SME restructurings to evaluate quickly whether a business can be rescued, the US experience has shown that some flexibility can be beneficial to the process. The need for more time is often driven by the difficulty in getting sufficient creditor participation to approve a plan when the debtor’s capital structure comprises numerous small claims.25 In some cases, more time is needed to finalize negotiations with stakeholders,26 and in the absence of a US-style "cram down" power,27 creditor engagement will be critical in approving SDRP plans. While in other cases, simply allowing the debtor a little longer to propose and confirm a plan may be worth the wait.
1 The summary of the Proposed Reforms contained herein is based on the Australian Government’s Fact Sheet entitled "Insolvency Reforms to Support Small Business Recovery," 24 September 2020, https://ministers.treasury.gov.au/ministers/josh-frydenberg-2018/media-releases/insolvency (the "Reform Fact Sheet").
2 Australia’s temporary insolvency relief measures are currently set to expire on 31 December 2020. Those measures include (i) relief for directors from any personal liability for trading while insolvent in respect of debts incurred in the ordinary course of business, and (ii) increased thresholds for issuance of a statutory demand and the extension of response deadlines.
3 The Proposed Reforms seek to streamline the liquidation process by cutting liquidators’ investigative processes, mandatory meetings and reporting requirements. The liquidation reforms are not discussed herein.
4 11 U.S.C. §§ 1181-95.
5 Small Business Reorganization Act 2019 (US).
6 Brian A. Blum, ‘The Goals and Process of Reorganizing Small Businesses in Bankruptcy’ (2000) 4 J. 181 Small & Emerging Bus. L. 201-223.
7 11 U.S.C §§ 101 (41), (51D).
8 Reform Fact Sheet, n 1, 3.
9 American Bankruptcy Institute, ABI Commission to Study the Reform of Chapter 11, (2014) (the "ABI Report"), 287.
10 Coronavirus Aid, Relief, and Economic Security Act 2020 (US), §1113. The eligibility threshold is set to revert to its pre COVID threshold one year after its enactment, unless extended.
11 11 U.S.C § 101(51D).
12 Fact Sheet, n 1, 4.
13 We note that the Fact Sheet is ambiguous as to whether secured creditors can be bound by a plan if they vote in favour of it ⸺ even if their debt does not exceed the realisable value of their security interest.
14 Instead, Australian debtors in need of operational restructuring may seek to take advantage of force majeure clauses or breach their agreements thereby treating damages as an unsecured claim under the plan.
15 11 U.S.C. § 1190(3).
16 11 U.S.C. §§ 1191(e).
17 H. Rep. No. 109-31, Part 1, at 3 (2005), reprinted in 2005 U.S.C.C.A.N. 88, 89.
18 With respect to administrative fees, the Proposed Reforms will require the Small Business Restructuring Practitioner to act on a fixed fee basis during the SDRP period and develop a remuneration proposal to cover their management of the plan once it is in place. By contrast, Subchapter V allows the trustee to charge an hourly rate ⸺ but in a departure from ordinary chapter 11 plan confirmation requirements ⸺ permits SME debtors to pay administrative expenses over the life of the restructuring plan (rather than on its effective date). 11 U.S.C. § 1191(e). To the extent possible, Subchapter V debtors may seek to arrange for distributions under the plan to be paid automatically from a controlled account, in order to mimimise fees incurred by the trustee in its capacity as disbursing agent.
19 11 U.S.C. §§ 1181(b), 1183.
20 11 U.S.C. §§ 363(b), 364(a).
21 Reform Fact Sheet, n 1. However, the Proposed Reforms have made clear that the administrator will not have personal liability for debts incurred by the company.
22 11 U.S.C. § 1189.
23 Blum, n 6, at 206.
24 11 U.S.C. § 1181(a).
25 ABI Report, n 9, 292 (summarizing that "the main reason" for low creditor participation in SME cases is that "creditors in these smaller cases do not have claims large enough to warrant the time and money to participate actively in these cases") (internal citations omitted).
26 It also remains to be seen whether the Proposed Reforms will provide any room for debtors to revise or re-solicit votes on a plan based on creditor feedback. In the United States, it sometimes takes more than one attempt to get a plan confirmed. If SDRP debtors have only one shot to confirm a plan before they must commence a formal VA or enter a new streamlined liquidation procedure, restructuring opportunities may be missed.
27 The US Bankruptcy Court may confirm a Subchapter V plan over the objection of the debtor’s creditors, provided that such plan does not discriminate unfairly and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan. For a plan to be "fair and equitable" it must ordinarily commit all projected disposable income of the debtor to be received in a 3 to 5 year period to repaying creditors. 11 U.S.C. § 1191.
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