Sub-Chapter 5 Bankruptcy – Top 10 Key Benefits
On February 19, 2020, Congress enacted the Small Business Reorganization Act of 2019 (“SBRA”), also known as a Sub-Chapter 5 Bankruptcy, to help small businesses through the bankruptcy restructuring process. The intent of the Sub-Chapter 5 Bankruptcy is to provide small businesses with a faster and less expensive option for reorganizing under Chapter 11.
Introduction to Regulation A Offerings
Regulation A, often referred to as “Reg A,” provides an exemption from the registration requirements pursuant to the Securities Act of 1933 for issuers seeking to sell securities to the public. Opting for a Reg A offering allows an issuer to raise funds from the public without incurring the heightened expense and liability associated with the registration process of a full-blown public offering. In 2015, the Securities and Exchange Commission (SEC) introduced final rules to establish two tiers under Reg A—Tier 1 and Tier 2. While both tiers share some similarities, variations exist in their reporting obligations and offering limits.
Reg A Tier Comparison: Tier 1 vs Tier 2
Both Tier 1 and Tier 2 offerings require the submission of an offering statement, consisting of Form 1-A and supplemental information, to the Securities and Exchange Commission (SEC). Following the submission, Tier 1 and Tier 2 issuers must await qualification by the SEC before commencing sales in the offering.
Under Tier 1, issuers can raise a maximum of $20 million in a twelve-month period without the requirement for ongoing reporting from non-accredited and accredited investors. Issuers do not have ongoing reporting requirements but must submit a report on the final status of the offering to the SEC. Testing the waters is permissible either before or after filing the offering statement subject to state securities laws. One advantage of a Tier 1 offering over a Tier 2 offering is that Tier 1 financials do not need to be audited.
Securities sold under a Tier 1 offering are not considered Covered Securities, which means that issuers must still comply with each state securities commission by registering or qualifying the offering prior to selling. This process requires coordinated review and approval from each state.
Under Tier 2, issuers can raise a maximum of $75 million within a twelve-month period from non-accredited and accredited investors, but they are obligated to meet periodic reporting requirements. These include submitting annual reports, semi-annual reports, amendments to address changes in circumstances, and a report on the final status of the offering. Testing the waters is permissible either before or after filing the offering statement subject to state securities laws.
Securities sold under a Tier 2 offering are considered Covered Securities. As such, Tier 2 offerings are preempted from state review and qualification.
Despite the increased reporting requirements associated with a Tier 2 offering compared to a Tier 1 offering, Tier 2 accounted for 70% of Regulation A offerings from 2015 to 2019.
Regulation A, Tier 2 Issuer Eligibility
Any company formed in the United States or Canada is eligible to seek exemption under Regulation A, Tier 2, with the additional requirement that its principal place of business must be in the US or Canada.
Additional scenarios that would disqualify an issuer include:
- Investment companies required to register under the Investment Company Act of 1940, or a business development company defined in Section 2(a)(48).
- A blank check company
- An issuer disqualified under SEC “bad actor” qualification rules
Limitations exist on what kinds of securities can be offered under Reg A. For example, an issuer cannot issue fractional undivided interests in oil or gas rights, or similar interest in other mineral rights. They also cannot issue asset-backed securities as defined in Item 1101(c) of Regulation AB.
Regulation A, Tier 2 Federal Compliance Requirements
Form 1-A
Issuers undertaking a Regulation A offering are obligated to submit Form 1-A to the SEC, consisting of three parts: Part I (Notification), Part II (Information Required in an Offering Circular), and Part III (Exhibits).
Part I consists of general information about the issuer, the issuer’s eligibility, and general information about the offering, such as the type of securities being offered and the anticipated fees associated with the offering.
Part II outlines the information required in the offering circular. The offering circular is where the issuer furnishes comprehensive information about their offering for potential investors, including general information about the issuer and the offering, as well as risk factors for the investment, dilution, plan of distribution, financial information, management, and more. The structure of the offering circular is regulated to promote consistency and honesty. Once approved by the SEC, the offering circular must be provided to all potential investors participating in the Regulation A, Tier 2 offering.
Part III contains exhibits to provide further context or evidence to support the information shared in prior parts of Form 1-A. For example, an issuer should attach any voting agreements that impact the rights of the securities holders as an exhibit.
Form 1-A must be completed at least 21 days prior to the SEC’s qualification of the offering statement.
For further information, see the SEC’s guidance for completing Form 1-A.
A 'No Objection Letter'
The sale of Reg A securities cannot commence until the Financial Industry Regulatory Authority (FINRA) provides the issuer with a ‘No Objection Letter’. The ‘No Objection Letter’ indicates that FINRA has completed its review of the offering.
FINRA’s review consists of two rounds which take approximately 10 to 25 business days in total. After the review, FINRA will return one of three letters: a ‘No Objection Letter’, a ‘Defer Letter’, or an ‘Unreasonable Letter’. A ‘No Objection Letter’ signifies that the offering review is complete, and the issuer can proceed based off the information submitted. ‘A Defer Letter’ is granted if FINRA has concerns or questions and needs further documentation. An ‘Unreasonable Letter’ is given if FINRA deems that the terms of the offering do not comply with corporate financing rules.
Qualification
Once initial requirements are fulfilled, the SEC will provide a notice of qualification and the issuer will choose their qualification date. Issuers must wait until the SEC’s approved qualification date to begin official sales of the offering. The qualification date is reported in state securities filings.
Testing the Waters
Although the sale of Reg A securities cannot commence until FINRA provides the issuer with a ‘No Objection Letter’ and the SEC qualifies the offering, there is a process known as “Testing the Waters” in which the issuer can lawfully gauge investor interest prior to qualification. By testing the waters, issuers are permitted to solicit interest in a potential offering from the general public, even before the filing of the offering statement.
Ongoing Compliance
Adherence to federal securities laws extends beyond the initial requirements. Issuers must satisfy ongoing reporting requirements. The following reports are the most common forms of maintaining ongoing compliance. This list is not all-inclusive and issuers should do thorough investigation into additional reporting requirements for their specific circumstances.
1-K Annual Report
Issuers of Reg A, Tier 2 offerings are required to submit electronic annual reports through EDGAR within 120 days of the issuer’s fiscal year end. Through the 1-K, the issuer discloses business operations from the past 3 years (or, if established less for than 3 years, since inception) and provides updates to information submitted in Part I of Form 1-A.
1-SA Semiannual Report
Tier 2 issuers must electronically file Form 1-SA within 90 calendar days of the end of the first 6 months of the issuer’s fiscal year. In this report, the issuer discloses interim financial statements.
1-U Current Report
Reg A, Tier 2 issuers must submit 1-U reports within four business days of significant events.
Significant events include:
- Fundamental changes
- Bankruptcy or receivership
- Material modification to the rights of securityholders
- Changes in the issuer’s certifying accountant
- Non-reliance on previous financial statements or a related audited report or completed interim review
- Departure of the principal executive officer, principal financial officer, or principal accounting officer
- Unregistered sales of 10% or more of outstanding equity securities
1-Z Exit Report
The 1-Z is an exit report that is mandatory for all issuers involved in Tier 1 offerings, and it must be submitted within 30 calendar days following the conclusion of their Regulation A offering. Tier 2 issuers are only required to disclose termination of the offering if it was not disclosed previously in a 1-K annual report.
Regulation A, Tier 2 State Compliance Requirements
Introduction to Blue Sky Compliance
Blue sky laws are state regulations designed to prevent securities fraud. The term originates from the depiction of the unregulated securities industry as speculative, where offerings were deemed to have “no more basis than so many feet of blue sky.” Blue sky laws vary based on the state where the offering is sold.
Under Regulation A, Tier 1, the securities sold are not deemed Covered Securities. As such, issuers must still comply with each state securities regulations by either registering or qualifying the offering prior to selling. This process requires coordinated review and approval from each state.
Under Regulation A, Tier 2, the securities sold are deemed Covered Securities. As such, states are preempted from requiring registration or qualification of offerings. However, states can, and often do, mandate notice filings.
In-Depth Blue Sky Compliance Resource
Understand more about state Blue Sky compliance for Reg A, Tier 2 offerings by downloading our resource, The Path to Blue Sky Compliance.
Understand more about state Blue Sky compliance for Reg A, Tier 2 offerings by downloading our resource, The Path to Blue Sky Compliance.
Reg A, Tier 2 Notice Filings
Submission of notice filings is the most common state compliance requirement for Reg A, Tier 2 offerings. A majority of states require notice filings, with only 12 states not mandating notice. Although the filing itself is similar between the states, variations exist in the timing, filing fee amount, issuer-dealer requirements, and method of filing from state to state.
For example, state filing fees could be a flat fee or variable based on the offering’s sales. The map below demonstrates the wide range in fees between the states, from $0 to $1,000+.
Ongoing Compliance
Adherence to state blue sky laws extends beyond the submission of initial notice filings. States often mandate annual renewal filings. In most states, the renewal is due one year from the date of the initial notice delivery to that state. However, Illinois requires a renewal filing one year from the qualification date. These nuances, while seemingly small, can affect whether an issuer complies with state securities laws.
In addition to meeting annual Reg A, Tier 2 renewal obligations, issuers must monitor their sales in each state to prevent “over selling.” This is crucial in states with variable fees, as these fees are contingent on the sales figures declared in the initial filing. If an issuer surpasses the sales initially reported in a specific state, they are required to amend their filing to reflect the updated projected sales amount.
Take for example Texas, where the filing fee for a state notice is 1/10 of 1% of an offering. When submitting an initial notice filing, an issuer could denote that they anticipate selling up to $75,000,000 in Texas, but that would land them with a $75,000 filing fee. This leads many issuers to try to provide a closer estimate of the amount they anticipate selling in Texas. If the issuer instead denotes that they anticipate selling $2,000,000 in Texas, they will have a $2,000 filing fee. However, if the offering goes well and it looks like there are investments totaling $3,000,000 in Texas, the issuer must amend their initial filing and pay an additional fee to avoid an over sale.
Navigating Compliance
While there is a lot of guidance available through the SEC, the nuances of compliance with federal and state securities laws are difficult for any issuer to navigate. Looking for assistance with launching and managing the compliance of your Regulation A, Tier 2 offering? Don’t hesitate to reach out to our team for assistance.
For many years, financially distressed small businesses were unable to utilize Chapter 11 in the same way large businesses could because the process was too expensive, too lengthy, and simply not feasible. The SBRA offers small businesses the same benefits larger debtors receive in a regular Chapter 11 bankruptcy including reducing liabilities, rejecting burdensome leases and executory contracts, eliminating debts, and selling assets but facilitating the bankruptcy process at a lower cost and a faster pace. The SBRA streamlines the plan of reorganization process, enabling small businesses to successfully emerge from bankruptcy with a court-approved plan within 90 days after filing for bankruptcy.
Right as the SBRA went into effect in February, its purpose and potential took on a whole new meaning. No one could have foreseen the pandemic that was about to take an unprecedented toll on the world and the economy. In response to COVID-19, on March 27, 2020, Congress enacted the Coronavirus Aid, Relief and Economic Security Act (“CARES Act”) to provide emergency assistance and health care response for individuals, families and businesses affected by the pandemic. The CARES Act makes some important changes to various provisions of the United States Bankruptcy Code, and, together with the SBRA, provides debt relief for small businesses unlike anything the Bankruptcy Code has provided before.
Here are 10 of the key benefits of Sub-Chapter 5 Bankruptcy:
1) Small Business actually means Small Business
To qualify as a small business debtor, the debtor must be a person or entity engaged in commercial or business activity with total debts (both secured and unsecured) not larger than $7.5 million. There is one exception: a single asset real estate entity, e.g., a debtor who derives substantially all of its gross income from the operation of a single real property, does not qualify under the SBRA. There is no requirement that the 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-petition debts arose from such activities.
2) Increase in Debt Limit
Under the SBRA, a business qualifies as a “small business” if its debts are in the amount of $2,725,625 or less. The CARES Act increased the debt limit from $2,725,625 to $7.5 million, provided that 50% or more of those debts arise from business or commercial activities. This change in the debt limit applies only to cases filed after the CARES Act became effective and is applicable for one year. After one year, the debt limit for cases under Sub-Chapter 5 will return to $2,725,625 absent an extension by Congress.
The increase in the debt limit will substantially increase the number of businesses that are eligible for relief under the SBRA and should benefit not only small business owners, but also their creditors, suppliers, customers, and employees, and, by extension, the overall economy.
3) No Official Committees Required
In a regular Chapter 11 bankruptcy, the U.S. Trustee appoints an official committee of unsecured creditors. If the committee does not like a proposed plan, it will object. This delays the process and often serves as an obstruction to getting a plan of reorganization approved. In a Sub-Chapter 5, a committee does not get automatically appointed but is instead only appointed by order of the court. In small business cases, the appointment of an official committee will be the exception, not the rule. This will also reduce the administrative burden on the small business debtor of having to pay fees and expenses incurred by the committee’s professionals.
4) Change in Professionals
In a regular Chapter 11 bankruptcy, the debtor cannot hire professionals if they hold a pre-petition claim against the bankruptcy estate. The SBRA provides that professionals are not disqualified from employment by a small business debtor if the professional is owed less than $10,000 prior to the date of the bankruptcy filing. This is also helpful for a small business debtor who may not have the funds to provide its bankruptcy counsel with a retainer prior to filing for bankruptcy.
5) Reduction in Administrative Costs and Fees
The SBRA reduces administrative costs and fees for the debtor. For example, small business debtors are exempt from paying U.S. Trustee fees, which are fees based on a company’s disbursements.
6) Appointment of Standing Trustee
In a regular Chapter 11 bankruptcy, a Chapter 11 trustee is appointed only for cause, such as fraud or gross mismanagement, and seizes control of the debtor’s operations. Under Sub-Chapter 5, a “standing trustee” is automatically appointed, but the debtor retains control of its assets and operations. The Sub-Chapter 5 trustee is similar to the trustee in a Chapter 13 individual debtor bankruptcy. The Sub-Chapter 5 trustee’s main role is to facilitate a consensual plan among the debtor and its creditors, similar to a mediator. This may be helpful in reaching a resolution among the debtor and its creditors, and may be particularly useful for a small business whose creditors are unwilling to make reasonable concessions in light of the impending financial crisis.
The trustee will be involved throughout the life of the case, examining and objecting to claims, reviewing the debtor’s financial condition and business operations, appearing at hearings, distributing property per the confirmed plan, and ensuring compliance. Under the supervision of the Department of Justice, approximately 250 Sub-Chapter 5 trustees – mostly attorneys and accountants – were selected out of over 3,000 applicants. Most Sub-Chapter 5 trustees had recently received their first case assignments when the COVID-19 pandemic hit.
7) Only Debtors Can File Plans
In a regular Chapter 11 bankruptcy, any party-in-interest can file a plan once the debtor’s “exclusivity period” has expired. The SBRA authorizes only the small business debtor to file a Chapter 11 plan of reorganization. This is a marked difference that is sure to help the debtor.
8) Streamlined Plan Process and Requirements
Under the SBRA, the plan process is much more streamlined and designed to keep cases moving quickly, which should help conserve administrative costs. A small business debtor must file its plan of reorganization within 90 days after entering bankruptcy unless the court extends this deadline “if the need for the extension is attributable to circumstances for which the debtor should not justly be held accountable.” It seems likely, in the current climate of economic and world health uncertainty, courts are likely to grant extensions liberally.
The SBRA provides for a shortened timeline to file a plan:
- Not later than 60 days after the bankruptcy filing, the bankruptcy court will hold a status conference “to further the expeditious and economical resolution of a case under this subchapter.”
- Not later than 14 days before the status conference, the debtor’s bankruptcy counsel is required to file a report that details the steps the company and its advisors have taken to attain a consensual plan of reorganization.
- Unless the debtor requests an extension related to circumstances outside of its control, the Chapter 11 plan of reorganization must be filed not later than 90 days after the bankruptcy case is filed.
Once the debtor completes all payments according to the plan, the reorganized debtor will receive a discharge from all of its pre-confirmation debts.
Much like a Chapter 13 case for individuals with regular monthly income, Subchapter 5 allows a small business debtor to spread its debt over 3 to 5 years, which benefits both debtors (by allowing them to spread payments over time) and creditors (by allowing them a meaningful recovery from debtors who may not have much money on hand but have a realistic expectation of increased income in the future). A plan of reorganization will generally be confirmed by the bankruptcy court so long as it provides that all projected disposable income of the debtor for 3 to 5 years will be used to make plan payments; or the value of property to be distributed under the 3-5-year plan, beginning on the date on which the first distribution is due, is not less than the projected disposable income of the debtor. In a traditional Chapter 11 case, administrative expenses must be paid at plan confirmation; under Sub-Chapter 5, they may be paid over the life of the plan.
9) Mortgage Modification and Protection
Sub-Chapter 5 makes it harder for creditors to take away a business owner’s residence pledged as collateral to support the business. For example, if the owner of the small business debtor used his or her primary residence as security for a loan to fund the small business, the debtor can seek to modify the mortgage against the primary residence, provided that the mortgage loan was not used to acquire the real property but was used primarily in connection with the debtor’s business.
10) Retention of Equity
The SBRA offers small business owners the opportunity to retain their ownership interest in the reorganized company. In a regular Chapter 11 bankruptcy, generally equity holders will lose their equity in the reorganized company (unless they provide new value to fund a plan of reorganization or the plan provides for payment in full to all unsecured creditors). Under Sub-Chapter 5, the plan may permit the owners of the small business debtor to retain their stake in the reorganized debtor, as long as the plan is “fair and equitable” with respect to each class of claims and interests and does not discriminate unfairly. Additionally, Sub-Chapter 5 eliminates the so-called “new value rule,” which normally requires equity holders to provide “new value” if they want to retain their equity interest in the business.