Individual Employs New Small Business Bankruptcy Law to Modify MortgageSmall businesses often struggle to reorganize in bankruptcy. To address this issue, Congress passed the Small Business Reorganization Act of 2019 (the SBRA). The SBRA took effect in February 2020 and makes small business bankruptcies faster and less expensive.

The recent case of In re Ventura, 2020 WL 1867898 (E.D.N.Y. Apr. 10, 2020) addresses many notable issues under the SBRA. In that matter, the debtor owned and operated a bed and breakfast out of a historic mansion, which was also her home. The debtor financed her purchase of the mansion with a $1 million loan. The debtor filed a Chapter 11 bankruptcy and proposed a plan to bifurcate the mortgage into secured and unsecured claims. The court ruled that the plan was not confirmable because applicable law at the time prohibited modifying a mortgage on a primary residence.

The SBRA went into effect during the debtor’s bankruptcy, and now allows modification of certain mortgages secured by a primary residence. The debtor took advantage of the change in the law, and amended her petition to designate herself as a small business debtor. The mortgage lender and U.S. trustee objected.

Amending a Prior Petition

As an initial matter, the SBRA is silent as to whether it applies to pending cases, or only cases filed after the effective date. In Ventura, the U.S. trustee acknowledged, and the court agreed, that there was no absolute bar to retroactively applying the SBRA to pending cases. At least two other bankruptcy court decisions allowed debtors to amend their petitions to take advantage of the SBRA.

Nonetheless, the trustee raised procedural concerns with allowing the debtor to amend her petition. The SBRA has strict deadlines for a status conference and plan filing. Since the debtor filed her case 15 months earlier, she missed these deadlines. The SBRA does allow an extension of the plan deadline “if the need for an extension is attributable to circumstances for which the Debtor should not be justly held accountable.” The court held that, since the SBRA did not yet exist at the time of filing, requiring the debtor to comply with the deadlines would be “the height of absurdity.”

The lender also argued that allowing the debtor to proceed under the SBRA would amount to a “taking” of its right to propose a competing bankruptcy plan. The court explained the relevant question was whether allowing the debtor to designate herself as a small business debtor impaired the lender’s rights as they existed prior to the SBRA. The debtor’s choice to amend her petition did not amount to a taking of property because the lender retained its right to recover the value of the mansion.

Designation as a “Small Business Debtor”

The Ventura court also analyzed whether the debtor qualified as a “small business debtor,” which is defined as a “person engaged in commercial or business activities” that has “aggregate, noncontingent, liquidated secured and unsecured debt of less than $2,725,625. . . not less than 50 percent of which arose from the commercial or business activities of the debtor” (11 U.S.C. § 101(51D)). In response to the COVID-19 pandemic, Congress raised this debt limit to $7.5 million for one year until March 26, 2021.

The mortgage lender argued that the relevant debts did not arise from the debtors “commercial or business activities,” because she previously filed bankruptcies where she categorized the same debts as consumer debts. The court disagreed. The real question was whether a specific debt was “incurred with an eye towards profit.” Fifty percent of the relevant debts arose from commercial activities because the debtor’s “primary purpose of purchasing the Property” was to operate the bed and breakfast.

Stripping Down a Mortgage Under the SBRA

The court then had to decide whether or not the debtor could modify, or “strip down,” the mortgage on her primary residence under 11 U.S.C. § 1190(3), a tool unavailable to individuals in a typical Chapter 11. Under this section, a debtor can modify a claim secured by a mortgage on a principal residence so long as the new value received in connection with the mortgage was (1) not used to primarily acquire the real property; and (2) used primarily in connection with the small business of the debtor.

The court chose to hold a future evidentiary hearing on these questions, but not before identifying five factors it planned to consider: (1) whether the mortgage proceeds were used in furthering the debtor’s business; (2) whether the property was an integral part of the business; (3) the degree to which the property was necessary to run the business; (4) whether customers must enter the property to use the business; and (5) whether the debtor uses employees and other businesses to run the operations.

The Evolution of Caselaw Under the SBRA

There is little doubt that the economic turmoil stemming from the outbreak of COVID-19 will drive the development of SBRA caselaw. With many small businesses temporarily shuttered, it is only a matter of time before courts see an increase in small business filings. Further, debtors with struggling Chapter 11 cases may take this opportunity to amend their petitions and designate themselves as small business debtors under the SBRA. Creditors should monitor the developing caselaw and be prepared to preserve their rights in these new small business cases.