December 22, 2022

At some point in nearly every trade creditor’s career, they will be faced with a customer who files for bankruptcy. The steps taken to collect cash from a customer during bankruptcy will depend on how the customer files. Subchapter V is a newer modification of Chapter 11 for small businesses, but it places a larger burden on creditors to collect debt.

“The intent with Subchapter V is to streamline the process, and make it more efficient and less expensive for the debtor,” Jason Torf, Esq., creditors’ rights attorney and partner at Tucker Ellis LLP (Chicago) said during Subchapter V of the Bankruptcy Code: Its Impact on Trade Creditors. “But at the same time, it strips away certain elements of a traditional Chapter 11 that are beneficial to creditors.”

Credit professionals may be sitting on a ticking time bomb without even knowing it. In fact, most (40%) creditors do not know what percent of their portfolio is made up of customers who qualify for Subchapter V bankruptcy, according to a recent eNews poll—and the 31% who do know the answer say 10% or more of their portfolio qualify for Subchapter V.

Creditors must be aware of how many of their customers could file using this subchapter because it makes it much more difficult to collect debt. You might even consider placing eligible customers in a higher risk category “because there will be a lot more factors working against the creditor if the customer files,” Torf explained. “There is an additional layer of risk with Subchapter V that does not exist in the traditional Chapter 11 route, and debt recovery is not as successful.”

Is Your Customer Eligible?

Subchapter V went into effect in February 2020, which means its third anniversary is coming up in 2023. Only small-business debtors whose total debts do not exceed $7.5 million can file for Subchapter V. The initial debt threshold was roughly $2.75 million, but the CARES Act increased that limit for another two years—and the expectation is that the $7.5 million threshold will become permanent.

But just because a customer files for Subchapter V does not mean they are actually eligible. The first step to protecting yourself is checking to make sure the customer actually qualifies. “There are so many more benefits to a creditor in a traditional Chapter 11 than a Subchapter V so don’t just accept that because the debtor filed for Subchapter V, that they actually qualify,” Torf explained. “Do your research to see if they are actually eligible because they might be trying to take advantage of the benefits that come with the subchapter.”

The state in which a customer files also can impact eligibility, for example, in re Offer Space, LLC, No. 20-27480, 2021 WL 1582625 (Bankr. D. Utah April 22, 2021), the court ruled that Subchapter V does not require an operating business in order to be eligible as long as the debtor is engaged in “business activities.” However, a court in Pennsylvania ruled a debtor ineligible under similar circumstances. “The lesson from this is if you have a customer who files for Subchapter V bankruptcy, take a close look at where they filed and what the court in that state has determined,” Torf said.

Since the first case was filed in the Middle District of Tennessee on Feb. 19, 2020, a total of 1,643 bankruptcies were filed pursuant to Subchapter V or converted to a case under Subchapter V filed within its first year. The most Subchapter V cases filed during its first year were in the Middle District of Florida with more than 140 cases. Districts within Florida, California and Texas rounded out the top five, per Bloomberg Law.

“In the three years that Subchapter V has been around, there have been successful cases where the debtor was able to reorganize and stay in businesses,” Torf said. “And there have been cases where creditors have been paid in full or paid a percentage of what was owed. But the favor in these cases typically lies with the debtor.”

Subchapter V Traps

In a Subchapter V case, a creditors’ committee is not automatically appointed, which “strips unsecured creditors from having a seat at the table in the same manner as in a traditional Chapter 11,” Torf explained. “This allows the debtor to confirm a plan that is not in any benefit of the creditors and that might not have been confirmed under a Chapter 11 because the creditors’ committee would speak up and object.”

Subchapter V is a much quicker process than Chapter 11. “Bankruptcy deadlines are always short and easy to miss, but Subchapter V deadlines can be even shorter,” said Lynnette Warman, Esq., partner at Culhane Meadows PLLC (Dallas, TX). “If you see that a case is under Subchapter V, don’t wait. If you have a big enough claim, hire an attorney right away and if you’re going to file a proof of claim, get that on file right away.”

Another difference about Subchapter V that is not in favor of the creditor is a lack of the absolute priority rule. Under Chapter 11, creditors have to get paid according to priority, with equity last in line. But under Subchapter V, existing owners can retain ownership of the business even without paying unsecured creditors in full—as long as the debtor pays those creditors all “projected disposable income” over a three-to-five-year period.

Torf has seen a Subchapter V case where the debtor’s proposed plan showed substantial payments in terms of bonuses and compensation to its insiders—equaling more than what they were paying unsecured creditors. It is a way for the debtor to artificially decrease disposable income. “They’ve utilized the Subchapter V process to their benefit by shifting money from creditors to insiders,” he said. “We think that’s an unfair use of Subchapter V, and we want to see a plan that takes out some of those unnecessary expense items and shifts money to unsecured creditors.”

Subchapter V can “incentivize” debtors to put forth projections in its plan that minimize its disposable income so they can pay the least amount possible to creditors, and creditors do not have a chance to vote against that plan. If the debtor exceeds its income projection, the debtor gets to keep that money.

What Are Your Options?

Even though there is no creditors’ committee in a Subchapter V, creditors can still ban together and hire counsel to form an ad-hoc committee. Members of that group can split the cost of counsel. “A creditors' committee might be more aggressive, or might take actions that a Subchapter V trustee would otherwise take,” Torf said. “For instance, an investigation of transfers or maybe alter ego companies that management might be running.”

Creditors still have some of the same general rights that they have under a traditional Chapter 11, such as secured and unsecured claims, reclamations, 503(b)(9) claims, the right to object to a plan and the option to not sell to a debtor post-bankruptcy. But creditors should also be aware that Subchapter V cases are more likely to fall in favor of the debtor. “The standards are relaxed compared to a standard Chapter 11, but I think there’s a bit of bias in favor of the debtor, both in the code provisions and in the mindsets of judges,” Warman said.

Over the last three years, we all have been thrust into a seemingly endless state of chaos—between the pandemic, war and economic instability. But what matters is how we choose to handle chaos at every level—whether it is as small as spilling your morning coffee or as large as a seismic shift in your organization.

In order to handle added pressure and chaos in the workplace as it comes, Chris DeVany, president at Pinnacle Performance Improvement Worldwide, recommends following a set of “core operating principles.”

1. Velocity: assess the speed at which a situation needs to be resolved.
2. Ownership: share ownership of the situation with someone else, making it easier to find a solution.
3. Innovation: rethink and redeploy existing resources to effectively resolve an issue.
4. Collaboration: problem solving is done best with the help and perspective of others.
5. Execution: put the solution strategy to work—implementation matters.
6. Planning: preparation will help you to not be overwhelmed or rushed.
7. Prioritizing: some situations require our immediate attention more than others. Categorize and compartmentalize are your two best friends when problem solving.

When problems and chaos arise, one of the most important skills to have is being able to separate what the current situation is and your desired outcome, DeVany said. Once you agree on both, strategize by brainstorming for two to five different ways to solve your problem. In the third step, implement your action plan and check your results. If the first doesn’t work, go back to the list and try again. “Hopefully, by no later than the second attempt, you successfully solved the problem, finished the project and are ready to move on to the next situation or problem,” DeVany explained during a NACM webinar, Handling a Chaotic Work Environment.

DeVany is the instructor for NACM’s new Strategic Leadership Track at Credit Congress in Grapevine, Texas. With more than 25 years of management consulting experience, DeVany will lead you on an exciting journey from operational to strategic leader. He has worked with the likes of Microsoft, Visa International, GM, Starbucks, Uber, Ulta Beauty and Chipotle.

Register for Credit Congress today and be sure to select the option of adding the Strategic Leadership Track during checkout. Spread the knowledge and bring a colleague who has never before attended a Credit Congress at a special rate of $249.

Businesses have been facing shocks on multiple fronts these days, from COVID-19 and inflation to the conflict in Ukraine and other escalating geopolitical tensions. COVID-19 and the Russian invasion of Ukraine particularly turned global supply chains upside down and intensified disenchantment with the trend toward globalization that has dominated world commerce for decades. 

In the face of these challenges, business leaders are urgently seeking ways to bolster supply chain resilience. Often, the first port of call has been to increase the level of stock in company warehouses. This has led to a dramatic rise in inventory levels across the globe and higher operating costs, especially given current global inflation. But while it is often a useful, short-term tactic, other solutions can be more sustainable for the long term. 

In our work with industrial clients around the world, we have examined many different approaches that companies are taking and studied how they can be combined into resilient, longer-term supply chain strategies. Based on this corporate input, we’ve put together an overview of essential strategies available to companies, how they interact and the implications of choosing one over another.

The key to success is ensuring that new supply chains are more robust than the ones they replace. And the more companies approach supply chain decision-making intentionally and holistically, the more likely they will develop long-term sustainability.

Trade Troubles and Consumer Interests

First, some context on pressures facing the supply chain: After decades of globalization and economic liberalization, continued trade growth can no longer be taken for granted. The global financial crisis of 2007 through 2009 left many suppliers with payment issues. While the financial system ultimately recovered, global trade remains down by eight percentage points from its peak in 2008. On top of slowing global trade came the introduction of trade sanctions between the United States and China, followed by COVID-19 and the challenges of maintaining supply when much of the world economy was shuttered. 

This series of shocks has led many to question globalization itself. Consumer attitudes in the electronics industry reveal that in countries such as France, Germany and India, most consumers now believe “the world is too globalized.” While those in China and the U.S. remain more positive about globalization, it is by a margin of just 4% and 6%, respectively.

The experiences of the past two years have also led consumers to take much stronger interest than before in questions about the origin of products. Interest in these matters is up 29% in the United States, for example. When buying electronics, 65% of consumers focus on domestic brands and 74% on locally produced devices. This is especially the case when issues of quality and trust are involved.

Additional Geopolitical Pressures

Recent events are also raising questions about companies’ continued dependence on China and its lengthy supply routes. The share of trade in China’s economy is on the decline, falling from a high of 35% before the financial crisis to less than 20% today.

Russia’s invasion of Ukraine could prove the biggest test of all. The conflict has already pushed up prices of oil and gas significantly. Low fuel prices have correlated historically with periods of high economic growth. The recent surge in commodity prices is adding to a dangerous inflationary spiral. 

Even if peace comes soon, sourcing commodities or components from Russia and Ukraine will remain out of the question for the foreseeable future. 

Ways Forward

In response to these challenges, companies are looking for ways to bolster supply chains so they might ride out future storms. Ultimately, the last few years have shown us that companies can be more flexible and adaptive than expected.

Build up inventory. The quickest and simplest way to increase resilience is to increase inventory. This acts as a buffer against disruption—but it comes at a cost. Economists have suggested the recent rise in inventory costs is equivalent to 1% of global gross domestic product (GDP). Currently, this is a price many companies view as worth paying, but there is a long-term question of whether the strategy is sustainable. 

Regionalizing the supply chain. Regionalization allows companies to view the supply map as a series of interconnected but largely independent ecosystems. It has led companies to source commodities, such as textiles, wood products and metals, closer to their customer base, from locations such as India, Mexico, Poland and Vietnam. The impact of regionalization by numerous firms has had such a big impact that it has increased the GDPs of these countries. 

Regionalization helps limit the risk of disruptions affecting all regions simultaneously. It also provides companies with the opportunity to potentially cut emissions and up their game in applying the sustainability criteria of environmental, social and governance (ESG) programs.

Nearshoring supply and production. Relocating production and supply closer to home gives companies greater control. Like regionalization, it also potentially decreases the carbon footprints of supply chains.

There are numerous recent examples of nearshoring. For example, one U.S. toymaker recently announced it would invest $50 million in a manufacturing plant in North America, after years of manufacturing most of its goods in Asia. Likewise, in December 2020, a major U.S. computer chipmaker announced it would invest hundreds of millions of dollars in domestic production facilities. 

Making the Best Decisions

Chief operations officers recognize that future supply strategies need to be more flexible and resilient—but reshaping supply chains can be a complex and time-consuming task. To help speed the process, leaders can use a decision-making matrix to assist in thinking through these challenging decisions. 

The matrix helps identify the most optimal combination of sourcing and warehouse management approaches for a company’s circumstances. It focuses on two key dimensions: the complexity of the product and the customers’ demand for the timeliness of supply. This produces four quadrants with distinctive characteristics. For each, the framework identifies which approaches can be combined to greatest effect.

Not every circumstance warrants such investment. For example, products of low complexity, where timely supply is less important, are unlikely to justify such interventions.

Longer-Term Strategy

While speed is of the essence in developing short-term tactical responses to supply-chain challenges, strategy is necessarily longer-term in nature. Companies need to incorporate tactical measures to ensure increased resilience during the implementation phase. But implementation itself is likely to consist of multiple stages, especially when the new approach entails both nearshoring production and localizing supply. 

Assessing these short- and long-term possibilities isn’t easy. But companies that can find the right mix of responses can build a supply chain that proves resilient over the long haul. 

This article originally appeared on Brink News.

Data in the U.S. and Europe pointed to a weakening of inflationary pressure. Supplier delivery times fell considerably in November while Baltic Dry Index (cost of shipping goods) is down to the pre-COVID levels. However, the U.S. jobs market remained strong, despite highly publicized announcements of layoffs. Federal Reserve Chair Jerome Powell reinforced market sentiment that future rate hikes would be moderate and that it was still possible that the Fed could achieve a soft landing. On the other hand, the global yield curve inverted for the first time in two years.

Credit conditions improved slightly to the 96^th percentile of the period from 1990 to the present. The 100^th percentile indicates the best credit conditions during that period. The Kamakura Troubled Company Index closed November at 8.20%, compared to 8.33% the month before. The index measures the percentage of 41,500 public firms worldwide with an annualized one-month default probability of over 1%. An increase in the index reflects declining credit quality, while a decrease reflects improving credit quality.

At the end of November, the percentage of companies with a default probability between 1% and 5% was 6.11%. The percentage with a default probability between 5% and 10% was 1.17%. Those with a default probability between 10% and 20% amounted to 0.66% of the total; those with a default probability of over 20% amounted to 0.26%. Short-term default probabilities ranged from a low of 7.92% on November 25 to a high of 8.32% on November 1. The largest change was among the percentage of riskiest companies between 1% and 5%, which dropped by 0.22%.

In the current risk environment, there are three key areas of rising risk: default risk, interest rate risk and market-liquidity risk. Higher borrowing costs, higher debt service coverage and difficulty in rolling over debt raises the risks of default. The rapid rise of inflation and the inverted yield curve, compared to negative interest rates of recent history, are challenging investors, lenders and borrowers alike. The changing risk factor relationships, the potential for a catalyst to require central bank intervention and enhanced market-to-market risk could transform an isolated event into a liquidity crisis quickly.

In this environment, the key is understanding how to navigate uncertainty. This demands that you “know what you don’t know,” know what you can control, avoid black boxes and have a plan enabling you to respond swiftly. Among the most important strategies are developing an early warning system to detect regime changes and monitor for contagion, as well as having the ability to execute a rebalancing of your portfolio if conditions necessitate such action.

These strategies require high-frequency updates and recalibrations to your models, as well as automation in data quality, feature engineering, model deployment and model performance monitoring. An integrated balance sheet view and the use of multiple models have never been more important. The technology for these capabilities exists today. Risk managers will likely have to battle expense mandates within their organizations to ensure they have the tools necessary to avoid potential losses as the markets continue their journey down an uncharted path.