The American Bankruptcy Institute (ABI) has just released its findings following a three-year study of Chapter 11 bankruptcy law, involving hundreds of bankruptcy professionals and academics and the study recommends (among other things) significant changes to the way smaller businesses are treated during bankruptcy proceedings, notably giving family-run businesses a way to retain control post-petition.

“The SME principles should create an equity retention structure that would appropriately align the interests of prepetition management and equity with the debtor’s reorganization and protect the interests of unsecured creditors, despite noncompliance with the traditional absolute priority rule,” says the ABI report.

Founders reluctant to cede control to their creditors

According to the ABI report, one of the clear problems with current Chapter 11 bankruptcy laws is that they are too expensive and onerous for smaller companies to make effective use of them, so by the time an SME (which ABI defines as a private company with less than $10 million in assets) files for bankruptcy it’s too late to do anything but liquidate. And even though the firms are too small to make headlines, they actually account for the bulk of Chapter 11 bankruptcy proceedings.

revenue of 2013 Chapter 11 bankruptcy

One of the main hurdles is that many SMEs are either family businesses or mostly run by the original founders. When it comes time to work out a restructuring plan, founders usually won’t go along with anything that requires wiping out their equity even if that’s what would be required under the absolute priority rule. To work around this, the ABI commission recommends creating a structure where SME equity holders would get to hold on to their voting rights in the reorganized entity, but with no more than 15% economic interest in the new entity. This keeps them involved, but recognizes that equity holders have to cede economic ground to creditors.

Procedural changes to SME Chapter 11 bankruptcy

The ABI report also recommends some procedural changes that are supposed to make Chapter 11 bankruptcy more accessible to SMEs. Under the current law, SMEs have 45 days from the petition to confirm their plan and then 300 days to file it: the first deadline is impossible for some SMEs to meet while the second creates all kinds of problems. The ABI would replace this with a single 60-day deadline for SME petitioners to establish a timeline for filing its plan and soliciting acceptances.

Finally, Chapter 11 bankruptcy proceedings are meant to give creditors a central oversight role, but their claims are often too small for SME creditors to be bothered. To prevent SME Chapter 11 filings from becoming aimless and ineffective, the ABI recommends appointing an ‘estate neutral’ to take on that oversight role instead.