Fourth Circuit Rules That Corporate Small Business Debtors Under Subchapter V May Not Be Able to Discharge All Debts

The Fourth Circuit’s decision[1] can be read here.

Background

In 2018 Mr. Vincent Cleary left his position at Cantwell-Cleary Co., Inc. (the “Plaintiff-Creditor”) and founded Cleary Packaging, LLC (the “Defendant-Debtor”), which began competing with the Plaintiff-Creditor. Plaintiff-Creditor alleged that Mr. Cleary took with him employees and sensitive customer information, and it initiated state court litigation against the Defendant-Debtor and Mr. Cleary for intentional interference with contracts, tortious interference with business relations, and related claims. The Plaintiff-Creditor secured a jury verdict in its favor and an approximately $4.72 million judgment (the “Judgment”).

The Defendant-Debtor, thereafter, filed a bankruptcy petition under chapter 11 and elected to proceed as a small business debtor under subchapter V. In its subchapter V plan, the Defendant-Debtor proposed to pay the Plaintiff-Creditor on account of the Judgment the aggregate total of only $140,489.77 over the five-year term of the plan and to discharge the $4.58 million remainder.  

In response, the Plaintiff-Creditor filed an adversary proceeding seeking a declaratory judgment that the Judgment is not dischargeable in bankruptcy under Bankruptcy Code sections 1192(2) and 523(a). Section 1192 provides that subchapter V debtors with non-consensual plans[2] are entitled to a discharge of most of their debts but not, among other things, any debt “of the kind specified in section 523(a) [of the Bankruptcy Code].”[3]  Section 523(a) provides a list of certain types of debts that cannot be discharged by individual debtors in bankruptcy under chapters 7, 11, 12 and 13 and subchapter V, including debts arising from a debtor’s “willful and malicious injury . . . to another entity or to the property of another entity[.]”[4]  In the litigation that went to the Fourth Circuit it was not disputed that the Judgment was a debt “for willful and malicious injury.”

In line with other bankruptcy courts that have considered the issue,[5] the Bankruptcy Court agreed with the Defendant-Debtor that the exceptions to discharge embodied in section 523(a) are not applicable to corporate debtors (only to individual debtors) and dismissed the adversary proceeding.[6]  Like the other courts, the Bankruptcy Court reasoned that the section 523(a) discharge exceptions can only apply to individual debtors because the introductory language of section 523(a) reads, “does not discharge an individual debtor from any debt[,]”[7] implying that section 523(a) is inapplicable to corporate debtors.

Analysis

The Fourth Circuit disagreed, held that 523(a)’s discharge exceptions apply to corporate debtors with non-consensual plans in subchapter V cases, and reversed and remanded the Bankruptcy Court’s decision. Notwithstanding the restrictive language in 523(a)’s preamble, the Fourth Circuit reasoned that section 1192(2)’s reference to debts of the kind specified in section 523(a) “indicates that Congress intended to reference only the list of non-dischargeable debts found in § 523(a)” and not the type of debtors to which section 523(a)’s discharge exceptions apply.[8]

Additionally, the Fourth Circuit reasoned that this interpretation is consistent with that of virtually identical language under chapter 12 (which is limited to family farmer and family fisherman debtors).[9]  Like subchapter V’s section 1192(2), section 1228(a)(2) also provides chapter 12 debtors with a discharge of their debts except, in pertinent part, “any debt . . . of a kind specified in section 523(a)[.]”[10]  Like the Fourth Circuit’s reasoning in the present case, courts have interpreted the section 523(a) discharge exceptions to apply to both individual and corporate[11] chapter 12 debtors notwithstanding section 523(a)’s introductory language restricting its application to individual debtors.[12]  According to the Fourth Circuit, if Congress did not intend for section 1192(2) to be interpreted the same as section 1228(a)(2) has been interpreted, Congress would not have used virtually identical language.

Takeaways

Up until now, corporate debtors have been able to discharge virtually all debts in Chapter 11. Cleary Products is a substantial disruption for potential subchapter V debtors with debts of the kind listed in section 523(a) of the Bankruptcy Code and for the subchapter V trustees of such debtors whose mission is to facilitate the confirmation of consensual subchapter V plans. The decision is a boon for creditors who can allege that they hold such claims.

The Fourth Circuit’s decision results in an inconsistent and uncertain scope of the discharge for corporate subchapter V debtors that cannot be ascertained until late in the debtors’ bankruptcy cases. Section 1192’s incorporation of section 523(a) discharge exceptions does not apply to consensual subchapter V plans. Whether a subchapter V plan is consensual or not turns on class voting, which is not set until solicitation of the plan is complete (late in a debtor’s case) and is not determined by the actions of individual creditors. If the Defendant-Debtor in Cleary Products happened to have some other large unsecured creditors that voted in favor of the plan, it could have carried the class over the objections of the Plaintiff-Creditor. In such case, the subchapter V plan would have been consensual, and section 523(a)’s discharge exceptions would not apply. On the contrary, as was the case in Cleary Products, because the Plaintiff-Creditor’s claim was large enough to carry the class, the subchapter V plan was non-consensual, the section 523(a) discharge exceptions applied, and the corporate Defendant-Debtor could not receive a discharge of the Plaintiff-Creditor’s claim. The distinction between these two scenarios occurs irrespective of any actions of the Defendant-Debtor or Plaintiff-Creditor and may not be fixed until late in the subchapter V cases. This, the Bankruptcy Court reasoned, leads to arbitrary results that undermine “the equality principles of creditor treatment under the [Bankruptcy] Code.”[13]

Moreover, creditors who can allege they hold claims of the kind listed in section 523(a) large enough to control a class will now have little to no motivation to consent to any impaired plan treatment for their claims, absent concessions a debtor would not otherwise have to make. If a proposed subchapter V plan does not pay the creditors’ claims in full, the creditors can block the consensual confirmation of such plan, necessitating the confirmation of a non-consensual plan under which their claims are not discharged (if they are found, in fact, to fall under 523(a)).

For now, the Cleary Products decision is only binding on subchapter V cases pending in districts in Maryland, North and South Carolina, Virginia, and West Virginia. Nonetheless, as the first circuit level decision on the issue, Cleary Products may be highly persuasive to courts in other districts. Corporate entities with debts that could be alleged to be of the kind identified in section 523(a) of the Bankruptcy Code that are contemplating a subchapter V filing need to consider this before filing a case. Potential corporate debtors who are able to file only in a district in the Fourth Circuit, or who are otherwise wary that their potential bankruptcy court may adopt Cleary Products’ holding, must evaluate whether filing as a subchapter V debtor, in lieu of a traditional chapter 11 filing, is the prudent choice.

ArentFox Schiff’s Bankruptcy & Financial Restructuring group will continue to monitor developments in this area. If you have any questions, please contact George P. Angelich, Adam J. Ruttenberg, M. Douglas Flahaut, Justin A. Kesselman, or Nicholas A. Marten.

[1] In re Cleary Packaging, LLC, No. 21-1981, 2022 WL 2032296 (4th Cir. June 7, 2022).

[2] Consensual subchapter V plans are those in which each class of claims either voted to accept the plan or were left unimpaired under the plan. 11 U.S.C. §§ 1129(a); 1191(a). Non-consensual subchapter V plans are those where one or more impaired classes of creditors did not vote in favor of accepting the plan but the plan nevertheless can be confirmed pursuant to section 1191(b) of the Bankruptcy Code. 11 USC § 1191(b).

[3] 11 USC § 1192(2) (emphasis added).

[4] 11 USC § 523(a)(6).

[5] In re Satellite Restaurants Inc. Crabcake Factory USA, 626 BR 871 (Bankr. D. Md. 2021) (holding that subchapter V does not expand the application of section 523(a)’s exceptions to discharge to corporate debtors); In re Rtech Fabrications, LLC, 635 BR 559 (Bankr. D. Idaho 2021) (same).

[6] In re Cleary Packaging LLC, 630 BR 466 (Bankr. D. Md. 2021).

[7] 11 USC § 523(a) (emphasis added).

[8] Cleary Packaging, 2022 WL 2032296 at *4.

[9] Id. at *5.

[10] 11 U.S.C. § 1228(a)(2) (emphasis added).

[11] A corporation may be a family farmer or family fisherman debtor if more than 50% of its stock is held by one family and its relatives, and they conduct the farming or fishing. 11 USC §§ 101(18)(B) and (19A)(B).

[12] See, e.g., In re JRB Consol., Inc., 188 BR 373, 374 (Bankr. WD Tex. 1995).

[13] Cleary Packaging, 630 BR at 467.