The worst of the pandemic may be over, but many small businesses are headed for a reckoning.

As relief efforts like the Paycheck Protection Program (PPP) wind down, and state and federal protections such as eviction moratoriums begin to lapse, companies that may have been limping along or on the edge could soon topple.

Or as Bob Keach, head of Bernsteinshur's business restructuring and insolvency practice, puts it: "Expect a total avalanche of bankruptcies soon."

It sounds counterintuitive, but "filings tend to be at their highest during the early stage of the recovery," says Keach. A bankruptcy filing is effectively a court order that governs how an insolvent debtor, who can be a business owner or an individual, will deal with unpaid obligations.

Why more businesses would elect to file now--in a recovery--all boils down to options: "Debtors want to file when they have options, and creditors cause filings when they have options," says Keach. 

In periods of stagnation--particularly at the bottom of an economic curve--not a lot happens because not a lot can happen, Keach explains. Lenders aren't being altruistic by allowing you to delay making payments; they want to get paid. (There's an industry term for it: extend and pretend.) But because their hands may have been tied during the pandemic by authorities or because they know it might be a PR boondoggle to force a company to liquidate during a crisis, they hold off, says Keach. Given time and an easing of conditions, they'll act.

Debtors themselves might hold off filing for protection until a recovery because they will presumably have more credit sources. Waiting until the economy improves may give businesses some flexibility in restructuring or refinancing legacy debt, says Keach. Plus, should a restructuring involve an infusion of new capital, he adds, it would be an easier sell to lenders if your business has brightening prospects.

Warning Signs

Early signs are pointing toward the surge that Keach predicts. Namely, the number of Subchapter V bankruptcy filings is rising. Subchapter V--so named for the section of the U.S. Bankruptcy Code in which it inhabits--marks a serendipitous bankruptcy reform for small businesses that became law in February, 2020, just ahead of the pandemic. Authorized by the Small Business Reorganization Act of 2019 (SBRA), Subchapter V makes reorganizing or liquidating less costly and less time intensive for small companies than filing for the traditional Chapter 11 reorg. The number of these filings increased by 55 percent in February, 59 percent in March, and 112 percent in April 2021, over the same months in 2020, respectively. 

Further, the Federal Reserve in its latest semi-annual Monetary Policy report, released in February, noted "business leverage now stands near historical highs." The central bank added that, as such, "insolvency risks at small and medium-sized firms, as well as at some large firms, remain considerable."

Globally, business insolvencies--that is, companies reporting economic distress--are expected to grow 26 percent this year, with the annual tally hitting 9 percent in the U.S., according to a March forecast from Atradius, an Amsterdam-based credit insurer. That marks a significant increase from 2020, when insolvencies declined by 14 percent globally and fell 5 percent in the U.S.

Behind the fall

In the last year, faced with unprecedented health and economic crises, millions of businesses applied for federal aid in the form of PPP loans, Economic Injury Disaster Loans, and Main Street Lending Program loans. They also sought out traditional Small Business Administration-backed loans that--thanks to the Economic Aid Act, which passed in December 2020--were sweetened to include a temporary cessation of fees and interest, and payment subsidies up to $9,000 through September 30 or as long as funds last. All told, the SBA has doled out more than $1 trillion in aid across its various programs since the onset of the pandemic, according to Bill Briggs, the former director of the SBA's office of capital access. He adds that the SBA has even more crisis-era lending authority, too.

That's on top of the business owners' pre-pandemic debts, which may have grown during the outbreak. On average, home equity line of credit balances of small business owners jumped up 3.4 percent between February and May 2020, while those of overall individuals declined 0.6 percent over the period, according to an analysis of individual-level data from the New York Fed's Consumer Credit Panel and Equifax's commercial database. 

While some debts--like PPP loans that end up receiving forgiveness--won't need to be repaid, forgiveness itself remains a big open question for millions of borrowers. The SBA helped underwrite more than 10 million loans worth north of $780 billion since last April. It's likely that some of these loans won't get forgiven, says Melissa Peña, chair of the bankruptcy and creditors' rights group at Norris McLaughlin in Bridgewater, N.J. In that case, she adds, "to the extent that the PPP might not be forgiven, a company might need to discharge that debt."

Plus, there's a clock on just about everything else. "Eventually people have to start paying that back," says Mike McGinley, executive vice president of small business banking at Live Oak Bank in Wilmington, N.C. Whether businesses will be able to stomach this repayment depends on how the economy responds, adds McGinley, who notes that an economic boom could go far in helping owners make good on debt payments. But that's not assured--particularly as the recovery has been uneven for many industries. "It's still a bit of a wait and see for small business," he says.

Tough Choices

Priscilla Luna of Today’s Business Solutions, pictured here with her mother Mely Jimenez, who co-founded the business with her husband Robert in 2003. inline image
Priscilla Luna of Today’s Business Solutions, pictured here with her mother Mely Jimenez, who co-founded the business with her husband Robert in 2003.COURTESY COMPANY

Business owners like Priscilla Luna of Today's Business Solutions are already making major changes to accommodate new-found financial pressures. To pay down a $750,000 credit line she tapped during the depths of the crisis, Luna says she's selling her firm's building, which has served as both showroom and a storage facility for her company, an office supplies, furniture, and technology reseller based in Houston. The initial payment? A sizable $200,000. "That location gave us more credibility with customers who visited us," says Luna. "It's going to be a hard change, but we have to do what we have to do."

The credit line, Luna says, was a lifeline in 2020. Whereas Today's Business Solutions booked $30 million in 2019, the company was off by more than a third in 2020. Despite getting a PPP loan in the first round, Luna says she still had to draw on the credit line to pay for everything from health insurance to employees' salaries. Meanwhile, she had to let go of six staffers, including members of her own family. "It was probably the worst day I've ever had," she says.

Some founders are lucky enough to be able to use grant money to retire their pandemic-related debts. Sara Dima, the co-founder of R&D Foods, a prepared foods and specialty grocer in Brooklyn, N.Y., says she's using her Restaurant Revitalization Fund grant to pay vendors, whom she put off last year when her company's revenue tanked. And some of what's left, which she declined to disclose to Inc., will go to retire another small loan which she says has a high interest rate.

"I also might pay us, as owners, a bit more," says Dima. "There were weeks last year where we barely took a salary so that we could meet payroll, pay vendors, pay rent etc."

If you're struggling with debt payments, there are out-of-court measures including negotiating directly with vendors and lenders, which Peña says remains a possibility these days. "I am seeing negotiations and forbearance agreements," she says. For others, reorganizing formally may be in order--though Peña points out that it should take place only after you've exhausted other options. "Usually we see it as a last resort," she says. "It is costly and it takes a lot of time and takes time away from management and time away from doing business."

If you must, however, at least Subchapter V bankruptcy protection, under SBRA, offers to ease the pain. "The Reorganization Act is bankruptcy lite," says Nick Oberheiden, a federal defense attorney in Dallas. "It's much faster and you get the same protections" as a traditional commercial bankruptcy proceeding, without a lot of the drawbacks.