New Federal Law Allows Business Owners to Restructure Second Mortgages and HELOCs
Small Business Reorganization Act expands protections for business owners' homes by permitting restructuring of second mortgages and HELOCs if proceeds used to fund business.
Congress passed the Small Business Reorganization Act ("SBRA"), which went into effect February 19, 2020, with the goal of creating a more streamlined and cost-effective mechanism for smaller enterprises to restructure debts and survive a temporary downturn. Originally, the law applied to businesses with up to $2.7 million in debt. But recognizing the value of the new provisions, and the economic fallout from the COVID-19 pandemic, the debt limit was bumped to $7.5 million as part of the CARES Act. This means that substantially more businesses and their owners, can take advantage of the unique SBRA provisions.
Most Small Business Owners Personally Back the Company's Debts
Most owners whose businesses rely on debt financing are required to personally guaranty the company's borrowings. In many situations the owner also grants a second mortgage on their home, or uses their home equity to fund the business, either through a cash-out refinance or home equity line of credit ("HELOC"). One of the most valuable provisions in the SBRA for business owners is the ability to restructure these types of debts and keep their home even if the business fails.
SBRA Home Mortgage Modification Requirements
Under the SBRA, modification of the debt requires that (1) the HELOC, the second mortgage, or even the primary mortgage was not used to acquire the real property, and (2) the “new value” was used primarily in connection with the business. This means that the loan was taken out by the small business owner to fund the business, and the business owner’s primary residence was used as collateral. Under the new provisions, the small business owner can now restructure that debt to make the terms more favorable for payback.
At least one court has already determined that even if the loan was taken out and used to fund the purchase of the primary residence, if the “primary” purpose was to fund the business, then modification is still permissible. In re Ventura, 615 B.R. 1 (Bankr. E.D.N.Y. 2020) (unlike chapter 11 and 13, the inquiry for SBRA is “whether the Mortgage proceeds were used primarily to purchase the Debtor’s Residence.”). Potentially, therefore, a business owner could receive a loan and use the money to purchase a home and fund a business as long as the primary purpose of the loan is not purchase of the home.
A further and very important benefit to business owners is the treatment of personal guarantees. Oftentimes small business owners are required to sign a personal guaranty when receiving loans for their businesses. A business owner needing protection from creditors can file an SBRA bankruptcy to treat and discharge the personal guaranty. There is no codebtor stay if only the business files, and not the individual. In that case, a creditor holding a personal guarantee can seek relief against the individual even though the automatic stay protects the business’s assets. The courts have already interpreted the SBRA broadly on this point finding that SBRA relief was available to a debtor who had guaranteed the debts of two LLCs that were no longer in business. In In re Wright, 2020 WL 2193240 (Bankr. D. S.C., April 27, 2020); see In re Blanchard, Case No. 12440, Doc. No. 137 (Bankr. E.D. La., July 16, 2020).
SBRA Debt Qualification Limits
In order to qualify for the SBRA, debt (secured and unsecured) may not exceed $7.5 million. This limit sunsets in 2021 (back down to $2.7) so timing to take advantage of this new law is critical. COVID-19 has provided unprecedented uncertainty, so many businesses needing to de-leverage can take cover in the pandemic to reorganize their debts. In other words, the SBRA can be a valuable tool to help a company get financially healthy; do it in a streamlined, less expensive manner, and not worry about a bankruptcy filing hurting their brand or business. Because so many businesses have used debt and leverage as a tool when interest rates have been low, the cover of COVID-19 and the excellent SBRA provisions are a reasonable and valuable solution to survive the loss of income caused by COVID-19’s economic uncertainties.
PPP Eligibility Considerations
One final note, despite the praiseworthy goals of the SBRA, there has been an inherent conflict with the CARES Act. The CARES Act provided $349 billion for small businesses under the PPP (“Paycheck Protection Program”). Neither the CARES Act nor the SBRA prohibits companies who have filed for Chapter 11 protection from receiving PPP loans, but a majority of courts have found that the required SBA loan application form that expressly disqualifies any small business in bankruptcy (and a subsequently enacted interim rule) means that the PPP money is unavailable. In a ridiculous, but necessary exercise of procedural gymnastics, companies are dismissing their SBRA Chapter 11 cases, obtaining the PPP loans, and then re-filing. Ideally, especially if a second wave of relief money is made available, the business would obtain the PPP money prior to filing to avoid the time and delay of having to dismiss and refile.
Conclusion
It is likely that the ramifications of COVID-19’s economic shutdown are not yet apparent. The Cares Act was a band-aid. August 8, 2020 is the deadline for application for the first wave of PPP money, and if there is a second round of PPP money, it is likely to be just a bigger band-aid. The other shoe is going to drop when banks, landlords and lenders run out of COVID-19 patience. In prior economic catastrophes, it was socially acceptable and normal for banks, lenders and landlords to apply pressure for payments due. With COVID-19, all creditors have been expected to refrain from everything from cutting off electric service, foreclosing, calling defaults, to even collecting rent. When that “expectation” runs out, and it will, the spigot will be wide-open and the effects of the economic shutdown will be felt in full. The smart move is to get ready now and talk with your legal and accounting professionals to be prepared.
EmergeLaw, PLC is a Nashville-based law firm focused on out-of-court workouts and Chapter 11 bankruptcy. Our experienced attorneys help companies and their owners make sound decisions and maximize value in the face of financial distress.