Thousands of SBA EIDL Loans will be Written Down or Wiped Out in Subchapter V
In 2020, in response to the Covid-19 pandemic, Congress authorized the Small Business Administration to make Economic Injury Disaster Loans (EIDL) available to small businesses impacted by the pandemic. According to the SBA, 4 million businesses were approved for $390 billion in EIDL funds.
Under the program, eligible businesses could borrow up to $2 million, with loan amounts based on prior years’ revenues, payable over 30 years at a fixed interest rate of 3.75%. Loans over $25,000 required that the borrower pledge its assets as collateral, although lack of collateral was not a basis for denial. What does that mean? It means that most of these loans are undersecured or completely unsecured and can be jettisoned in a streamlined Subchapter V restructuring.
Subchapter V History and Eligibility
Congress created Subchapter V to be a streamlined financial restructuring tool for small businesses. When the law became effective in February, 2020, it applied only to businesses with total debt of $2,725,625. When the Covid-19 pandemic hit shortly thereafter, Congress increased the debt limit to $7.5 million as part of the CARES Act. Any U.S. entity or individual engaged in commercial or business activity is eligible for Subchapter V so long as their total debts (excluding disputed, contingent, and unliquidated debts) do not exceed the $7.5 million cap.
Disposable Income Budget
The goal of a Subchapter V restructuring is approval of a Reorganization Plan that reduces overall debt to a manageable level. The foundation of the Plan is a 3-5 year budget that projects the company’s “disposable income” – which is defined simply as income that is not reasonably necessary for “payment of expenditures necessary for the continuation, preservation, or operation of the business…”
Included in the expenditures are anticipated payments to tax creditors and secured creditors under the Plan. Most tax claims can be paid over 5 years with interest, unless more favorable terms can be reached with the taxing authority. Secured creditors are those that hold collateral for their claims, but only up to the value of the collateral. So, for example, if a creditor is owed $150,000 secured by a lien on equipment, but the equipment is only worth $100,000, then the creditor will be treated as having a $100,000 secured claim to be paid based on fair market terms (which may be more favorable than prior terms), and a $50,000 unsecured deficiency claim, which will be treated as described below.
Whatever is left over from projected revenues after anticipated business expenses (which might include capital expenditures and a contingency allocation), tax claims and secured claims, is the company’s disposable income to be paid over 3 years (not to exceed 5 years) on a pro rata basis to the company’s unsecured creditors (which includes trade debts, deficiencies balances from secured claims, and most other actual or potential liabilities).
Whatever the bottom line of the company’s budget shows as free cash, or disposable income, is the amount that must be distributed to the pool of unsecured creditors over the life of the Plan (3 years by default, not to exceed 5 years). So, for example, if the disposable income number is $5,000 per month, then that is the amount the company must pay on a pro rata basis to unsecured creditors over the life of the Plan. It doesn’t matter if total unsecured debt is $5 million, and it doesn’t matter if the company exceeds the budget estimates in the future; if the Plan is approved based on management’s best guess about future performance, the Plan becomes the new contract between the company and all of its creditors.
Other Requirements for Plan Approval
In addition to committing all disposable income to creditors over 3 years (possibly up to 5 years), to be approved the Plan must also be feasible. Feasibility simply means that the company is more likely than not to be able to perform the requirements of the Plan and the budget. This is usually demonstrated through testimony of management, who typically knows more about the business than anyone else. No one has a crystal ball, and projections about future performance inherently involve a certain degree of guesswork. The bottom line is that the projections must represent management’s best guess about what the future holds and management must be prepared to explain and defend the budget if challenged.
To be approved, the Plan must also meet the “best interest of creditors test,” which is based on fundamental fairness. A Plan must propose to pay creditors over the life of the Plan more than the amount they would receive in a hypothetical forced liquidation.
Subchapter V is the Vehicle Many Business Owners will use to Fix Balance Sheets
To understand what makes EIDL loans a particularly attractive target for restructuring, it is important to first look at the nature of the loans. The SBA is a lender of last resort, and many EIDL loans were made during a time of desperation for borrowers, and made without regard to whether a borrower could pledge collateral. Many, if not most, borrowers would have been unable to borrow from a traditional lender on an unsecured basis. For the reasons discussed above, cutting unsecured debt is straightforward in Subchapter V.
The next thing to consider is that these loans have a 30 year term, with no payments due for the first 2 years. As payments are starting to come due, many businesses are realizing that this was not free money like forgivable PPP loans. As repayment begins, it triggers some business owners to take a hard look at their balance sheet and consider whether future prosperity is bogged down by the excess debt they took on during the pandemic. The long term and low fixed interest rate (3.75%) mean that monthly payments are intended to be manageable, and for many businesses they are. But managing cash flow on a month-to-month basis is mere survival. Growing and thriving in the long run often requires borrowing for expansion and other capital projects, and for many businesses the existence of an EIDL loan will make that impossible.
While the EIDL program was undoubtedly a lifesaver for many small businesses impacted by the pandemic, in the aggregate it represents a nearly $400 billion drag on American small businesses. Subchapter V is a streamlined process that, for many EIDL borrowers, will result in entirely wiping out the debt to the SBA.