Another US Circuit Court Holds Exceptions to Discharge Apply to Corporate Subchapter V Debtors
SINCE ITS ENACTMENT IN FEBRUARY 2020, SUBCHAPTER V OF CHAPTER 11 HAS BECOME A USEFUL VEHICLE FOR SMALL BUSINESSES THAT ARE LOOKING TO REORGANIZE OR OTHERWISE ADDRESS OPERATIONAL ISSUES, LIQUIDITY ISSUES, OR EXCESSIVE DEBT THROUGH INSOLVENCY PROCEEDINGS. CONGRESS ENACTED SUBCHAPTER V TO MAKE CHAPTER 11 MORE APPEALING FOR SMALL BUSINESSES THAT WERE PREVIOUSLY DETERRED FROM FILING DUE TO THE COSTS AND RISKS ASSOCIATED WITH THE "TRADITIONAL" CHAPTER 11 PROCESS. SUBCHAPTER V HAS BEEN A HIT AMONG ELIGIBLE DEBTORS: IN 2023, NEARLY HALF OF ALL CHAPTER 11 FILINGS WERE UNDER SUBCHAPTER V.
Why has Subchapter V been so well received by small business debtors? Well, because it provides a less expensive and more streamlined version of the traditional Chapter 11 process, yet gives debtors the ability to reap largely the same benefits of a traditional Chapter 11. So, it is no wonder that small business debtors have embraced Subchapter V. But everything comes at a cost, and in Subchapter V, unsecured creditor swept into a streamlined Chapter 11 process have borne that cost.
In a huge win for creditors that helps balance Subchapter V's pro-debtor provisions, the U.S. Court of Appeals for the Fifth Circuit has recently held that the Bankruptcy Code's exceptions to discharge apply where a nonconsensual plan is pursued by a corporate Subchapter V debtor (even though the exceptions do not apply to corporate debtors in "traditional" Chapter 11 cases). In doing so, the Fifth Circuit joined the only other Circuit-level court to address the issue, the Fourth Circuit, bucking what appeared to be a growing trend among lower courts that have held the exceptions to discharge do not apply to corporate Subchapter V debtors.
There may be an impending drop-off in Subchapter V filings because the debt limit for filing Subchapter V bankruptcy reverted to approximately $3 million on Friday, June 21, 2024 (a significant decrease from the temporary $7.5 million limit set in 2020 due to the financial distress caused by the pandemic). However, the possibility always exists that Congress will revisit the debt limit in the future given the popularity of Subchapter V among debtors and bankruptcy professionals.
In any event, creditors should remain mindful of the various advantages that Subchapter V provides to debtors. For example, in Subchapter V: (i) the debtor maintains the exclusive right to file a plan, (ii) the debtor may extend payment of administrative expense claims (e.g., claims for goods sold on credit during the bankruptcy case) over the 3-5 year life of the plan, and (iii) the absolute priority rule is abrogated in that equity holders may retain their equity interests in the debtor even if unsecured creditors are not paid in full so long as the debtor contributes its "projected disposable income" to fund plan distributions over the life of the plan. While the exceptions to discharge apply only with respect to certain, limited categories of debts, the advantages for a Subchapter V debtor will have an impact on the overwhelming majority (if not all) Subchapter V cases. Therefore, it is critical that creditors monitor and vigorously protect their interests in Subchapter V cases just as they would in a traditional Chapter 11.
KEY POINTS
- Subchapter V offers a less expensive and more streamlined version of the traditional Chapter 11 process.
- Subchapter V has been a massive hit among debtors, with nearly half of all Chapter 11 filings in 2023 being under this provision.
- While Subchapter V offers significant advantages to debtors—such as the exclusive right to file a plan, the lack of an official committee of unsecured creditors, the ability to defer payment of administrative expense claims over the life of the plan, and the ability to retain equity Interests even if unsecured creditors are not paid in full—these benefits come at a cost to the unsecured creditors who are swept into the streamlined process.
- In a crucial win for creditors that helps balance some of the above costs, the U.S. Court of Appeals for the Fifth Circuit ruled that the Bankruptcy Code's exceptions to the discharge of certain debts apply to corporate Subchapter V debtors pursuing a nonconsensual plan.
THE SPLIT REGARDING SECTION 523(A)'S EXCEPTIONS TO DISCHARGE
Section 523(a) of the Bankruptcy Code lists numerous types of debt that may be excepted from the discharge granted to a debtor in bankruptcy. Section 523(a) states that a discharge under Chapter 7, Chapter 11, Subchapter V, Chapter 12, and Chapter 13 of the Bankruptcy Code "does not discharge an individual debtor from any debt" for, among other things, debts that arise from a fraud, misrepresentation, materially false financial statements, defalcation in a fiduciary capacity, embezzlement, or a willful and malicious injury by the debtor. Section 523(a) specifically states that its exceptions to discharge apply to an "individual debtor" and the Chapter 11 provision that incorporates Section 523(a) into Chapter 11 cases (Section 1141(d)) does the same. As a result, corporate Chapter 11 debtors are usually not subject to Section 523(a)'s exceptions to discharge in traditional Chapter 11 cases.
Courts are split as to whether Section 523(a) applies to corporate debtors in small business Subchapter V cases. Although Section 523(a) specifically states that its exceptions only apply to "individual" debtors, Subchapter V's discharge provision, Section 1192, does not draw any distinction between individual and corporate debtors. Rather, Section 1192 states that where a nonconsensual plan is confirmed, "a debtor" is not entitled to a discharge of any debt "of the kind" specified in Section 523(a). In light of this, the U.S. Court of Appeals for the Fourth Circuit issued a decision in June 2022, in Cantwell-Cleary Co., Inc. v. Cleary Packaging, LLC, holding that Section 523(a)'s exceptions to discharge apply to individual and corporate debtors. The Fourth Circuit relied on Section 1192's broader language, further noting that Section 1192 is phrased virtually the same as Chapter 12's discharge provision, which has been interpreted to apply Section 523(a)'s exceptions to discharge to both corporate and individual debtors. The Fourth Circuit also reasoned that Congress had intended Subchapter V's small business provisions to generally apply to qualifying individual and corporate debtors alike, and Congress' intent would be frustrated if the discharge exceptions applied to one but not the other.
However, several courts, including in the Ninth Circuit, Michigan, Idaho and Maryland, have held the opposite—that the exceptions to discharge only apply to individual debtors, even in the Subchapter V context. For example, in its July 2023 decision in Lafferty v. Off-Spec Solutions, LLC, the Ninth Circuit Bankruptcy Appellate Panel (BAP) rejected the Fourth Circuit's ruling and held that Section 523(a)'s exceptions to discharge do not apply to corporate Subchapter V debtors. The Ninth Circuit BAP noted that while Section 1192 is silent on the types of debtors that are subject to Section 523(a), it says nothing to contradict that Section 523(a) is limited to individual debtors. In fact, when Congress amended Section 523(a) to include Section 1192 among the various discharge provisions to which Section 523(a)'s exceptions apply, Congress did not amend Section 523(a)'s limitation to individual debtors. The Ninth Circuit BAP concluded that Section 1192 should not be read as expanding Section 523(a)'s applicability to corporate debtors. As the Ninth Circuit BAP noted, limiting Section 523(a) to individual debtors is more consistent with the overall statutory scheme of Chapter 11.
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