While the United States Congress continues to play politics in extending additional relief to small businesses as a result of the COVID-19 pandemic, financial hardship continues to mount, and a wave of commercial and consumer vehicle lease and loan defaults is expected to crash over the United States and Canada in Q4 2020 and Q1 2021.
Consider this: according to industry experts, the 15 largest U.S. banks have set aside $76B to cover projected bad debts (this is a mix of auto and non-auto bad debts), and Chapter 11 filings were up 78 percent in the month of September 2020 compared to the prior year.
Lessors, beware! The perfect storm is offshore; the vehicle leasing and finance industry is not immune and should be prepared to manage what could be the most challenging economic period of our careers. Add a new section to the U.S. Bankruptcy Code that many commercial lessees and borrowers will avail themselves of and the perfect storm just got worse.
Subchapter V of Chapter 11, the Small Business Reorganization Act of 2019 (SBRA), was enacted by Congress on February 19, 2020, just weeks prior to the outbreak of the pandemic. It is an easier, less expensive, and quicker version of Chapter 11 reorganization for small businesses and individuals, provided their debts are primarily business debts and “engaged in commercial or business activities.”
Originally, Congress capped secured and unsecured debts under Subchapter V at $2.75M, but the CARES Act increased this ceiling to $7.5M until March 2021. The hope is that this increase will benefit debtors, creditors, and the economy in general.
To file under Subchapter V, a business must submit a recent balance sheet, a statement of operations, a cash flow statement, and its most recent federal tax return. If the business is unable to provide these items, a corporate officer must file a statement under the penalty of perjury that the form(s) have not been prepared and/or filed.
The most impactful aspect of Subchapter V for vehicle finance and leasing companies is that the debtor is not limited in modifying or cramming down motor vehicle loans as they are in Chapter 13. This means that in most cases the vehicle lender will be forced to accept payments equal to the market value of the vehicle even if the value is less than the amount of the loan. Think about this in today’s specialty vehicle market–the downside for lenders will likely be significant.
The effects of Subchapter V are less impactful in today’s used consumer vehicle market as auction prices remain elevated.
Compared to a traditional Chapter 11, this process is much quicker. A Subchapter V debtor has 90 days to file a plan, and the court will hold a status conference within 60 days after the plan is filed. There is no creditors’ committee unless there is cause, most likely debtor fraud.
The plan must be feasible, in other words, realistic, and the debtors must commit all of their disposable income to repay creditors for the plan term of at least three years, but not to exceed five years.
A trustee is automatically appointed, but the debtor retains equity and control of its assets and operations. The trustee’s role is essentially to act as a mediator to facilitate a settlement among creditors.
Additionally, if the debtor used his or her principal residence as security for a loan to fund the business, the Subchapter V plan allows the debtor to modify certain mortgages to save the residence from creditors.
Note that true leases, including many Lease Here Pay Here (LHPH) leases, may be treated differently under Subchapter V. Since this is a relatively new statute and the courts are still far behind in case management, there are no reported cases, as of this writing, in which true vehicle leases have been challenged in Subchapter V filings. However, it is likely that capital leases (finance leases) will be treated as vehicle loans for cramdown purposes. Stay tuned!
While some experts expect Subchapter V filings to surge once PPP funds run out, especially among small businesses that cannot meet the loan forgiveness criteria, so far filings are off to a slow start. However, as company capital continues to dry up, as the loan and lease deferrals end, as cash flow continues to diminish, and as many lenders pull back and tighten credit, commercial lessees are at a tipping point. Do they continue to support their operations and make their lease payments, or do they file under Subchapter V, put their creditors on pause, and reorganize?
Clearly, there is uncertainty for vehicle lessors and lenders going forward, but one thing is certain: it’s time to have conversations with legal professionals about how to best navigate the impending storm heading your way.