Representation of Small-Business Concerns on Creditors Committees

Representation of Small-Business Concerns on Creditors Committees

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In many instances, a bankruptcy can have a greater impact on the debtor's smaller business creditors than some of the larger creditors. However, due to the sheer size and power of the larger creditors, very often the smaller claimants are frozen out in the committee-selection process. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) adds new §1102(a)(4) to the Code to remedy this situation. This section resolves a split among the courts on the issue of whether or not the bankruptcy court has the power to increase the membership of a creditors' committee appointed by the U.S. Trustee (UST).1 It allows judges to direct the UST to increase the size of creditors' committees to include certain creditors who qualify as "small business concerns." This article briefly examines the new §1102(a)(4). It continues with an overview of nonbankruptcy law relating to the Small Business Act and small-business concerns, as well as a discussion of what constitutes a "disproportionately large" claim. The focus of what constitutes "adequate representation" is outside the scope of discussion of this article.

Section 1102(a)(4) of the Code

BAPCPA's revisions to the Code provide certain additional protections to smaller creditors. The second sentence of §1102(a)(4) of the Code provides that:

[t]he court may order the U.S. Trustee to increase the number of members of a committee to include a creditor that is a small business concern (as described in §3(a)(1) of the Small Business Act2) if the court determines that the creditor holds claims (of the kind represented by the committee) the aggregate amount of which, in comparison to the annual gross revenue of that creditor, is disproportionately large.

The revised Code raises two issues that are worthy of discussion and elaboration—first, whether creditors qualify as "small-business concerns," and second, whether a claim is disproportionately large as compared to the gross annual revenue of a creditor. While the first of these issues is easily resolved, the second is more troublesome. The following discussion will examine these two components of §1102(a)(4) in greater detail.

Small Business Concerns under the Small Business Act

The Small Business Act (SBA), 15 U.S.C. §631 et seq., sets forth the criteria for an enterprise to qualify as a "small-business concern" in §632. The business must inter alia be an enterprise that is (1) independently owned and operated, and (2) not dominant in its field of operation. A small-business concern may also be engaged in the business of agriculture or farming. However, to be deemed a small-business agricultural concern, the enterprise must have annual gross receipts that are less than $750,000.3

Additionally, §632(a)(2) of the SBA provides that the administrator4 may "specify detailed definitions or standards by which a business concern may be determined to be a small business concern." Under the statute, the agency can promulgate regulations that take into account the size and additional criteria such as "employees, dollar volume of business, net worth, net income, a combination thereof or other appropriate factors" when determining whether an enterprise qualifies as a small-business concern. The cases address several issues such as whether an affiliated company is deemed to be part of a larger group, and whether the regulations are enforceable.

Regarding the affiliation issue, in American Electric Company v. United States, 270 F. Supp. 689, 691-92 (D. Ha. 1967), a disappointed bidder brought an action for a judgment declaring that it qualified as a small-business concern. The company had annual sales in excess of $7.5 million—the amount at the time that was determined to be the ceiling for a company to qualify as a small-business concern in the particular industry at issue. However, the company had 18 affiliates. It argued that the Small Business Administration could not promulgate regulations that required the annual sales of all affiliates to be aggregated for purposes of determining size qualifications. The court sided with the government, ruling that large corporate concerns with small affiliates could otherwise reap the benefits of the Small Business Act. Later, in Aloha Dredging and Construction Co. v. Heatherly, 661 F. Supp. 738, 740 (D. D.C. 1987), the district court ruled that the determination of whether a company was affiliated with another for purposes of determining whether it was a small business concern would be determined under "the totality of all circumstances."

As to the enforceability of the regulations, in Otis Steel Products Corp. v. United States, 316 F.2d 937, 940 (Ct. Cl. 1963), the claims court ruled that since the administrator had the authority under the Small Business Act to define a small business concern, regulations that contained such a definition had the full force and effect of law. In effect, the Otis Steel case confers the authority of statute upon these regulations.

In Jones Truck Lines Inc. v. Republic Tobacco Inc., 178 B.R. 999, 1006 (Bankr. N.D. Ill. 1995), the bankruptcy court correctly noted that the Code of Federal Regulations "sets forth standards in the table of Standard Industrial Classification (SIC) for what qualifies as a small-business concern under the SBA." Therefore, an examination of the regulations is necessary to make the final determination of whether or not an entity qualifies as a "small-business concern."

The regulations promulgated by the Small Business Administration in 13 C.F.R. §121.101 provide that the SBA sets forth size standards for determining whether an enterprise qualifies as a small-business concern. The regulation references the North American Industry Classification System (NAICS) that provides industry codes. 13 C.F.R. §121.201 sets forth size standards in either millions of dollars of annual receipts or by number of employees, depending upon the particular industry. The regulation provides this information in excruciating detail and makes excellent reading for insomniacs.

Case Law Addressing Disproportionately Large Claims and Transfers

Unfortunately, qualifying as a small-business concern is not enough to get a small-business creditor a seat on a creditors' committee. The debt owed to the creditor must be "disproportionately large" in comparison to its annual gross income. The case law on this point is not particularly instructive. Indeed, there is no reported authority that defines the term "disproportionately large." That being said, there are a few cases that use this terminology, including several within the context of bankruptcy filings.

In Inland Security Company v. Estate of Kirshner, 382 F. Supp. 338, 350 (W.D. Mo. 1974), the district court considered the predecessor to §548 of the current Code. It held that when property is transferred or obligation incurred for purposes of security, it is only necessary that its value not be disproportionately large as compared with the amount of advance or debt secured for purposes of determining whether to avoid the transfer. The debtor in Kirshner gave a creditor with an unsecured claim of $12,354.97 a secured note of equal value. This, the court held, was "disproportionately large."

Another area in bankruptcy where the term "disproportionately large" has come into play is in the context of determining when to commence litigation. A trustee should not commence litigation if the cost of litigation is disproportionately large in relation to the probable recovery that would result therefrom.5 However, Bean provides little insight into the parameters of this term, merely citing a case that holds that when the cost of litigation exceeds the recovery, or when the anticipated recovery is a used car worth $1,300, the said litigation costs are "disproportionately large" compared to the recovery.

A case interpreting New York state law provides more defined boundaries. In Troll v. Chase National Bank of City of New York, 257 F.2d 825 (2nd Cir. 1958), the Second Circuit considered the term "disproportionately large" in the context of New York's fraudulent conveyance statute then in force. The debtor pledged bonds as collateral to a bank in exchange for a loan. The pledge was 43 percent greater than the amount of the debt. Citing a 1939 state court case, the Second Circuit held that within the context of the subject statute, a pledge of 52 percent more than the outstanding debt was not disproportionately large. However, it is unlikely that the percentages used in the Troll case will provide any meaningful guidance when interpreting §1102(a)(4).

Finally, in Musetter v. Lyke, 10 F. Supp.2d 944 (N.D. Ill. 1998), the court held that an award of $50,000 in exemplary damages was not disproportionately large in a case where compensatory damages exceeded $450,000.

It is anticipated that litigation over the issue of whether the claim of a small-business concern is "disproportionately large" compared to its annual revenues for purposes of §1102(a)(4) will be considered on a case-by-case basis. To date, the courts have simply failed to set forth a bright-line rule to provide guidance.


[B]eing a small creditor in and of itself is not enough to require committee membership under §1102(a)(4).

Conclusion

Section 1102(a)(4) of the Code demonstrates that while BAPCPA is perceived as legislation enacted primarily for the benefit of larger institutions, it does contain provisions that benefit smaller concerns as well. It clears up any confusion over the issue of whether or not courts may direct the UST to increase the membership of creditors' committees to include certain smaller creditors. In order to determine whether such creditors qualify as "small business concerns" under §1102(a)(4), one must look to the Small Business Act and regulations promulgated thereunder. The issue of whether or not a creditor's claim is "disproportionately large" compared to its annual gross revenues as required under §1102(a)(4) is less clear and probably will need to be resolved on a case-by-case basis. One thing is clear, however; being a small creditor in and of itself is not enough to require committee membership under §1102(a)(4). The practitioner should work through the various requirements of the statute to assure that his client qualifies for committee membership as a statutory "small-business concern" with a claim that is disproportionately large to its annual gross revenues before presenting such an argument to the bankruptcy court.

Lastly, it should be kept in mind that the language of the statute is not mandatory. The decision of whether or not a qualifying small-business concern should be added as a member of a creditors' committee is ultimately left to the discretion of the sitting bankruptcy judge.

Footnotes

1 As discussed in the April 2006 Last in Line column by Deborah L. Thorne, "Creditors' Committees: Maximizing Creditor Recoveries," ABI Journal, Vol. XXV, No. 3, p. 20, April 2006, BAPCPA returned the bankruptcy court's ability to review the contents and make-up of creditors' committees by resurrecting the pre-1986 §1102(c) in new §1102(a)(4). For the first time in many years, courts, practitioners and creditors have a more lucid understanding of the bankruptcy court's role in the committee-appointment process. Under the post-1986 revision, bankruptcy courts struggled with and failed to present a seamless web of continuity on the issue. The case law was more of a disjointed patchwork of decisions that could not be easily reconciled. See Klee, Kenneth N. and Shaffer, K. John, "Creditors' Committees under Chapter 11 of the Bankruptcy Code," 44 S.C.L.Rev. 995, 1032 (Summer, 1993).

2 The Small Business Act is set forth in 15 U.S.C. §631 et seq.; §3(a)(1) of the Small Business Act is set forth in 15 U.S.C. §632(a)(1).

3 See 15 U.S.C. §632(a)(1).

4 See 15 U.S.C. §662(2); the term "administrator" means the Administrator of the Small Business Administration.

5 See In re Bean, 251 B.R. 196 (E.D.N.Y. 2000).

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Thursday, June 1, 2006