abstract. To assist small businesses in the wake of an exogenous shock, Congress should consider implementing a system of lending that models the financing provided to small business debtors in a bankruptcy proceeding. Such a system would be more targeted, effective, and fair than traditional government loans, but less stigmatizing than bankruptcy.

Introduction

Small businesses are central to the economic health of the United States. Their survival following disaster is therefore essential to economic recovery. Small businesses employ nearly half of all American workers1 and create two out of every three new jobs.2 They also provide life and vibrancy to their local communities, encouraging economic activity and other beneficial community interactions.3

Due in part to their size, which necessarily limits capitalization and the capacity to spread risk, small businesses are particularly susceptible to exogenous shocks, such as natural disasters, international conflict, and domestic turmoil.4 The Federal Emergency Management Agency (FEMA) has reported that up to 40% of small businesses never reopen after a major disaster.5 The impact of natural disasters can fall heavily on small businesses and continue to be felt for years.6

Protecting small businesses from natural disasters is at the forefront of public-policy considerations. However, the best way to help small businesses recover from disasters is not readily apparent, especially not in the heat of the crisis. This is due, in part, to the fact that small businesses, while similar in many respects, are extremely diverse in terms of size, industry, financial health, resources, and growth prospects.7 Although all are “small,” the prevailing definition of small businesses includes sole proprietorships and companies with up to 1,500 employees or $41.5 million in annual receipts.8 As a result, government responses to exogenous shocks can easily miss the mark, particularly when they attempt to assist not only small businesses, but also large corporations and individuals.9 After all, policymakers have a duty to evaluate their approaches and expend public resources in a way that accomplishes the most good and does the least harm.

The congressional response to help small businesses in the wake of the COVID-19 pandemic, exemplified by the Payment Protection Plan (PPP), missed the mark by providing costly relief that failed to reach the firms that needed it most and limiting the use of relief funds in ways that prejudiced many small businesses. This Essay proposes an alternative federal response to future exogeneous shocks. That alternative approach uses the structure of a forgivable loan, incorporating principles of bankruptcy protection to encourage a more efficient use of funds while simultaneously avoiding the stigma associated with a bankruptcy filing. Part I provides a brief summary of the PPP, focusing primarily on the weaknesses of the program. Part II describes how a bankruptcy filing can help small businesses reorganize and preserve owner equity while acknowledging the limited perceived utility of bankruptcy for many small-business owners. Finally, Part III suggests an alternative approach that would combine the advantages of the PPP and bankruptcy protection, while avoiding many of their disadvantages.

I. the payment protection plan

The COVID-19 pandemic, which disrupted the normal operation of most American businesses from the spring of 2020 well into 2021, is a striking example of an exogenous shock that dramatically affected small businesses. There are important lessons to learn from the government programs that succeeded and failed in their efforts to provide assistance to small businesses as part of a larger response. In particular, this Essay analyzes the efficacy of the PPP, the most visible element of the government’s effort to aid small businesses affected by the global pandemic.

In the early days of the pandemic, federal, state, and local governments responded by encouraging social distancing.10 Although prohibiting large meetings and shutting down gathering places were necessary to protect public health, these measures threatened the economy, particularly for small businesses.11 In some ways, the pandemic was no different from other exogenous shocks. Hurricanes, floods, fires, and even riots may require businesses to cease normal operations to protect the health and safety of their customers and workers. Small businesses often suffer from short-term revenue loss after natural disasters, in addition to incurring costs from building and equipment damage caused by storms, loss of electricity, or looting. But the COVID-19 shutdown was substantially farther reaching and longer lasting than most disasters in living memory, resulting in a loss of revenue that was especially dramatic and persistent.12 For many small- and medium-sized enterprises, the government’s social-distancing policy had an unprecedented effect.13

Policymakers quickly realized that small businesses needed the government’s assistance to cope with the consequences of the pandemic.14 Leaving small businesses to their own devices was likely to have severe consequences for the larger economy.15 Based on research conducted by the Federal Reserve,16 it seemed inevitable that a substantial number of small businesses would be forced to lay off their employees or close entirely.

Indeed, the initial shutdowns in March of 2020 produced the largest spike in unemployment claims observed since the Great Depression.17 Significant numbers of small businesses temporarily closed due to the pandemic, reducing their staffs and suffering staggering losses in revenue.18 More disturbing, minority business owners experienced a much larger drop in revenue than average, even after controlling for industry variations.19

Faced with widespread business closures and potential large-scale unemployment, Congress decided to act. In considering different responses, lawmakers hoped to encourage ongoing employment by small businesses to minimize the effect of long-term unemployment on the economy.20 This determination was largely informed by the lessons of the 2008 recession. Lawmakers feared that unemployment caused by the pandemic could persist long-term, even after the worst effects of the pandemic had receded.21 Congress sought to incentivize small businesses to retain employees on the payroll by providing loans that could be forgiven if used primarily for that purpose.22 This program came to be known as the Paycheck Protection Program (PPP).

The PPP enabled eligible applicants to borrow up to 2.5 times their monthly payroll, up to a maximum of 10 million dollars.23 Unlike other Small Business Administration (SBA) loans, the PPP did not require collateral or personal guarantees for loan approval. Furthermore, borrowers could be eligible for forgiveness of their loans, so long as during the eight- to twenty-four-week covered period following loan disbursement, the business maintained the same number of employees and compensation, spending at least 60% of the loan proceeds on payroll costs.24 Financial institutions approved by the SBA made the PPP loans and administered the program, but the loans were guaranteed by the federal government.25 Although the SBA has engaged in other guaranteed-lending programs in the past, the size and scope of the PPP was unprecedented.26

Many businesses took advantage of the PPP. An estimate published by the SBA in June of 2020 reported that as many as 84% of all small-business employees were supported by the PPP.27 The amount of funds approved for disbursement steadily grew over the summer of 2020 and into 2021.28 By August 2021, the SBA had distributed over $790 billion of PPP funds.29 Later distributions of PPP funds introduced additional restrictions regarding the number of employees, and also required applicants to demonstrate at least a 25% reduction in gross receipts between comparable quarters in 2019 and 2020.30

The relief provided by the PPP was not equally distributed across small businesses. Especially for the initial distribution of PPP funds, firms with an outstanding lending relationship with SBA lenders had a significantly better chance of receiving funds. The program’s first-come, first-served nature meant that businesses without preexisting relationships were often left out in the cold. Businesses owned by women and minorities—groups who were less likely on average to have preexisting banking relationships—were therefore less likely to receive PPP assistance.31 PPP fund distribution was also criticized as inequitable for funding companies based on the size of their payroll, rather than the amount of their apparent need.32 Certain recipients of PPP funds—such as Ruth’s Chris and Shake Shack—are hard to describe as “small” businesses, despite apparently satisfying program criteria.33 Yet these larger businesses received a proportionately higher amount of funding, despite having access to wider resources than the typical small business struggling with the impacts of COVID-19.34

In the initial distribution of PPP funds, recipients were not required to demonstrate need apart from certifying that “[c]urrent economic uncertainty makes this loan request necessary to support the ongoing operations.”35 This may have been due in large part to the prevailing uncertainty regarding the pandemic’s length, severity, and geographical spread. For many businesses, particularly in industries such as construction, real estate, finance, and information and technology,36 the shutdowns in the spring of 2020 were only temporary. Many of these businesses were quickly designated as essential within their respective jurisdictions and were accordingly permitted to continue operating. These industries experienced a smaller reduction in their workforces and less disruption to their revenues, along with lower rates of closure.37 Nevertheless, many businesses within these industries applied for PPP funding in its early days out of an abundance of caution, and then used the funds to pad their reserves.38

Other businesses that had accepted PPP funds found the restrictions associated with loan forgiveness so onerous as to severely dilute the program’s benefits. As modified,39 the PPP required recipients to use 60% of the funds received for company payroll within twenty-four weeks of disbursement.40 Some businesses were heavily restricted from operating for all or most of that period, making payroll an unnecessary expense, as opposed to rent and basic utilities. These companies had to manufacture reasons for employees to work in order to obtain their loan forgiveness.41 In the meantime, federal unemployment assistance made it more lucrative for many low-wage employees to accept unemployment rather than work their normal hours.42 Employers thus found themselves competing with unemployment benefits to bring workers back to work in businesses that were closed or operating under heavily restricted conditions. On top of all this, many employers had mixed feelings about bringing employees back to conditions in which they might be vulnerable to infection.43 Some businesses applied for and received funding before they were permitted to open under applicable local regulations, and were accordingly unable to satisfy the initial, more stringent requirements for loan forgiveness.44

In sum, the PPP’s benefits to small businesses were limited, both because the most vulnerable small businesses had difficulty getting access to loans and because the payroll limitation tied the hands of other small businesses who desperately needed the funding to meet other expenses. Perhaps because of these weaknesses, many small businesses laid off employees throughout 2020 and 2021, leading to spiking unemployment figures.45 The majority of small businesses experienced a significant decline in sales46 and were forced to respond by cutting expenses,47 taking on additional debt,48 and, in some cases, closing their doors permanently.49 The PPP did not appear to dramatically improve the survival prospects of most small businesses.50

Of course, the PPP was not the only federal program used by small businesses during the COVID-19 pandemic. Many small businesses also applied for and received funding through a separate SBA program, the Economic Injury Disaster Loan (EIDL).51 The EIDL program extends more modest loans52 directly from the SBA53 on very favorable terms54 to small-business owners with dramatically fewer restrictions—albeit without loan forgiveness.55 Loans over $25,000 require the grant of a security interest in the business’s personal property, reflecting an emphasis on repayment.56

Federal funding through the PPP and EIDL programs did provide some assistance to small businesses struggling with the effects of the COVID-19 pandemic. However, the PPP largely failed to achieve its goals in providing needed assistance to the most vulnerable businesses, and it was unsustainable as a long-term solution due to its significant expense and potential for waste. As an initial matter, the program was extremely costly,57 particularly considering that it failed in its ultimate goal of reducing small-business layoffs. The program was also inequitable and ineffective in providing meaningful assistance to businesses that lacked the customer base to justify retaining employees.58 The format of the EIDL likely reduced the likelihood of waste as a consequence of emphasizing repayment.59 But it was also demonstrably less attractive to small businesses concerned about their ability to repay their debt over the long term.60 Accordingly, the EIDL’s more modest goals were muted, insofar as businesses opted for forgivable loans even when they proved less useful due to the restrictions imposed.

II. the small business reorganization act

Government lending programs poured a remarkable amount of public funds into the economy in an effort to forestall soaring unemployment and a likely recession. The effectiveness of this approach remains to be seen and warrants further study. Expanding the use of bankruptcy relief might have provided a more targeted approach by assisting those companies in the greatest need. The bankruptcy laws of the United States allow companies to propose a plan of reorganization that can be confirmed over the objections of creditors, and they permit companies to discharge debts, escape unprofitable contracts, and stay collection efforts during the reorganization.61 Many predicted that even with additional governmental aid, large and small businesses would widely invoke bankruptcy as a mechanism to stop collection efforts and obtain additional funding.62 Although this was largely true for big corporations, bankruptcy was not a widely used solution for small businesses.63

A full explanation of this phenomenon has yet to be determined.64 Uncertainty about the future may have played a large role in delaying bankruptcy filings during the pandemic, along with the lack of liquidity. But this explanation is somewhat unsatisfying, given that large corporations, facing the same uncertainty, filed for bankruptcy in record numbers in 2020,65 and evidence suggests that liquidity was unusually high during the early days of the pandemic in particular.66 Another theory might be that small businesses perceived less value in a bankruptcy filing, which is generally viewed as a mechanism to discharge debt, despite other advantages it can provide, such as the automatic stay and oversight of lending. Perhaps a better explanation is that until very recently, bankruptcy was not a particularly useful tool for small businesses seeking to reorganize. Historically, Chapter 11 proceedings were often too costly in terms of time, fees, and sacrifice of owner equity to benefit smaller organizations.67 Shortly before the pandemic commenced, Congress passed major reforms to the Bankruptcy Code aimed at facilitating small-business reorganization.68 But despite this felicitous timing, small businesses do not appear to have been sufficiently inspired to take advantage of the new law once the pandemic hit.

The Small Business Reorganization Act (SBRA), which passed in 2019 with an effective date of February 19, 2020, reduced the costs of filing for Chapter 11 bankruptcy (the chapter designated for business reorganization) by creating a subchapter V with comparably softer restrictions and requirements.69 For small businesses with debts under roughly $2.7 million, the SBRA reduced administrative paperwork requirements, shortened the timeframe for obtaining a plan of reorganization, and permitted equity owners to retain their interest even while discharging debt over the objection of creditors.70 These modifications removed the largest perceived drawbacks of Chapter 11 bankruptcy proceedings for small businesses.71 When the COVID-19 crisis hit, one part of the congressional response in the Coronavirus Aid, Relief, and Economic Security (CARES) Act was to raise the debt limits for qualification under the SBRA to $7.5 million.72 However, despite these advances and the objective need for relief among small businesses, there was no noticeable increase in bankruptcy filings among small businesses.73

The reluctance of small businesses to take advantage of the bankruptcy system may be partially attributable to the stigma surrounding bankruptcy, particularly among consumers and small-business owners.74 There are also real economic consequences to filing for bankruptcy that principally affect future credit worthiness.75

But bankruptcy proceedings provide a wide range of tools for small businesses seeking to overcome a dramatic economic shock. The filing itself invokes an automatic stay, halting all efforts by creditors to collect against the debtor.76 In particular, it renders void any act to repossess collateral, foreclose on collateral already possessed, or continue an eviction.77 This provides a “breathing spell” for the debtor to make determinations regarding what to do next.78 Debtors may also stretch out payments on secured assets, sell assets free and clear of any liens, and reject unprofitable contracts and leases.79 When acting as a “debtor in possession” (DIP) of the bankruptcy estate, a company may also take on additional debt in bankruptcy through what are commonly referred to as “DIP loans.”80 DIP lenders, who are frequently preexisting creditors or insiders of the debtor, benefit from the bankruptcy system’s transparency and the assurance of priority in repayment, even while other obligations are restructured or discharged.81

Although the primary purpose of a Chapter 11 filing is not for businesses to obtain a “fresh start,”82 but rather to reorganize debts to maximize future economic viability, filers may also obtain a discharge of debts. Under the classic Chapter 11 model, discharge is obtained by proposing a plan of repayment to which creditors consent, and all debts outside the plan of repayment are discharged upon the bankruptcy court’s confirmation of the plan.83 Outstanding unsecured debts, damages arising from rejection of contracts and leases, and cure amounts on secured obligations may all be discounted and paid out over time. Under subchapter V of the Chapter 11, enacted through the SBRA, small-business debtors need not obtain creditors’ consent to a plan and may instead obtain a discharge of outstanding debts upon a showing that they have used all disposable income to repay debts for a period of three to five years.84

These advantages are available in bankruptcy by virtue of federal laws that override state rights and remedies, which typically protect the property interests of creditors. Bankruptcy laws allow debtors to maximize the going-concern value of their businesses by restructuring their outstanding obligations. By limiting creditor rights to a quick recovery, the law permits insolvent debtors to look ahead to a future of productivity. However, by virtue of being associated with the term “bankruptcy,” a Chapter 11 filing may be ineffective as a disaster-relief mechanism, for the simple reason that many business owners would rather fail than file for bankruptcy, with its accompanying social stigma.85

III. the small business relief and restructuring act: an alternative approach

This Essay proposes a hybrid approach to disaster relief that incorporates bankruptcy principles, but avoids the stigma associated with bankruptcy filings, by structuring relief as a forgivable loan—similar to what Congress offered under the PPP.86 This proposal is more targeted than the relief offered by the PPP, and it also takes into account the challenges faced by business owners who personally guaranteed their business debts by providing temporary relief from collective actions. In addition, this proposal avoids the stigma of a bankruptcy filing, encouraging a broader uptake among small-business owners, similar to that observed with use of the PPP and the EIDL. A tentative title for such a proposal might be the Small Business Relief and Restructuring Act (the Act).

The Act would provide relief for small businesses, administered at the federal level, to be triggered upon the declaration of an emergency within that business’s federal district. Similar to applications for SBA loans, qualifying businesses would need to apply for this relief by filling out an attestation regarding their size, past experience with federal-benefit programs, and anticipated need. Furthermore, within a designated period, businesses would need to provide additional documentation demonstrating how their revenues have been affected by the disaster.

After satisfactorily demonstrating qualification for the program, small-business beneficiaries would be entitled to a general stay of collection proceedings, modeled after the automatic stay of the Bankruptcy Code, preventing evictions, foreclosures, repossessions, and the like for a predesignated period of six months, to be expanded if the business demonstrates that disaster conditions have continued beyond that timeframe. This targeted relief could take the place of broader moratoria on foreclosures and repossessions for businesses in the aftermath of an exogenous shock, although these policies may still be desirable for individual consumers.87 The stay would extend to personal guarantees applying to any outstanding business debts.88 During this period of stay relief, creditors affected by the stay could request compensation to protect their interest in a debtor’s assets. Qualification for and the amount of compensation would be determined based on the creditor’s sworn affidavit of loss caused by the stay, and it would be drawn from loans granted to the debtor through the program.89

In addition to the benefit of the six-month stay on collection efforts, businesses taking part in the Act’s restructuring program would qualify for loans to be administered directly by the SBA, similar to the EIDL program currently in place.90 Depending on the perceived risk, such loans could require the grant of security in business assets. Loan amounts would be determined primarily as a function of the company’s operating budget for one to three years, although flexibility would permit a larger or smaller loan depending on the purpose of the loan. Loans would be offered for the purpose of maintaining normal operations during a period of exogenous shock or for altering or reorganizing operations in the face of such a shock, but not for facilitating liquidation of the business. These loans would also be fully forgivable upon the loan recipients’ demonstration that they had successfully returned to profitability and had faithfully dedicated all disposable income (income not otherwise dedicated to operating costs) to repayment of the loan for three years. This standard would mirror that required for a nonconsensual discharge under subchapter V of Chapter 11.91 Firms that failed to return to productivity would not receive loan forgiveness, permitting the SBA to stand as a creditor with equal footing to others in the event of the firm liquidation. In the event that the SBA obtained a security interest, that interest would be fully enforceable in cases where the company did not qualify for loan forgiveness. In cases where the company had been sold or transferred to another entity, loan forgiveness would not be available, and the SBA’s rights would be fully enforceable against the purchaser.

Qualification for the loan and for loan forgiveness would be overseen by a plan administrator operating through the SBA. This administrator would be a disinterested third party, not a federal employee. These private individuals would function similarly to trustees in the bankruptcy system, particularly like the role envisioned for the subchapter V trustee.92 Most individuals filling this role would be trained in small-business finances. They might also be trained turnaround managers, specialized consultants trained to initiate corrective measures to guide a struggling firm through a financial crisis.93 As circumstances change for the business, the plan administrator would permit or deny requests for modification in terms and ultimately determine whether loan forgiveness is warranted. Officers would generally be overseen by government officials, likely through the SBA or even the Department of Justice.94

In short, without forcing small businesses to acknowledge a bankruptcy filing, the Act would allow for designated bankruptcy-like relief, with its balance of transparency for creditors and relief for filers. Creditors would benefit from the loan and in cases where the debtor qualifies for loan forgiveness, they would be paid in full. The role of trustee and judge in the bankruptcy court would be collapsed into the position of a plan administrator. This would reduce overall program costs and ensure a more tailored, need-based approach, along with ongoing oversight in cases like the COVID-19 pandemic where disaster conditions linger, and relief must be ongoing. This program would not replace full bankruptcy proceedings, which some borrowers might find necessary, but it would substantially assist companies struggling with external shocks who might not need or desire the full protections of a bankruptcy filing. It would also serve as a method to preserve preexisting debtor/creditor relationships, including landlord/tenant relationships, during a period in which both are under significant pressure due to exogenous forces. The program would combat unnecessary economic loss by providing short-term liquidity to enable small businesses to remain current on their obligations despite interrupted revenue and the introduction of additional costs.

By basing loan forgiveness on a can-pay system of repayment, the program would differ from the more uniform approach of the PPP and allow for alternative criteria for forgiveness from companies that do not hire outside employees, or who could not meaningfully benefit the economy by increasing or even maintaining payroll. As such, the proposed Act would more effectively target a broader cross-section of small-business owners. By limiting loan forgiveness to those organizations who successfully used the loan to return to productivity, it would also incentivize businesses to repay current creditors and return to normal operations. This approach could disrupt or discourage private negotiations, instead incentivizing debtors to repay other creditors and not the SBA loan. However, the fact that it would be limited to disaster scenarios likely to affect both creditors and debtors makes this result neutral or even desirable.

The Small Business Relief and Restructuring Act, or another program like it, would work best if established well in advance of eventual future disasters, to facilitate smooth administration and to ensure practitioners who advise small businesses are aware of its existence. Indeed, now may be a better time to act than ever, given that passage of such a program may be more politically feasible in the immediate aftermath of a significant disaster, such as the recent COVID-19 pandemic, than it would be in times of prosperity. With memories of the pandemic still fresh and shutdown-related hardships still lingering, policymakers are more likely to view such measures as a priority. As time goes on and other stories dominate the news, legislation for responding to disasters may lose its timeliness and relevance.

Conclusion

The COVID-19 pandemic was not the first crisis to shock small businesses, and it will not be the last. Our government will need to respond to similar disasters in the future. This Essay proposes an alternative approach to providing relief for small businesses in the wake of exogenous shocks, one that melds the benefits of easy financing with the accountability, oversight, and gatekeeping of the bankruptcy court, but that avoids the stigma of bankruptcy. Such an approach is essential for ensuring the ongoing viability of small businesses, the lifeblood of the U.S. economy.

My sincere thanks to Benjamin Means, Ted Janger, Ed Morrison, and Tony Casey for their encouragement and feedback.