Bankruptcy Court Approves Sub V Filing Amid EIDL Qui Tam Allegations

In an eligibility dispute in a Subchapter V Chapter 11 bankruptcy case, the United States Bankruptcy Court for the Western District of Michigan (the Court) ruled the debtor was eligible, concluding that debts asserted in a Qui Tam action against the debtor for alleged misuse of Economic Injury Disaster Loan (EIDL) funds were contingent and unliquidated.  The debtor’s scheduling those debts at $0.0 was not a lack of good faith. In re McPhillips Flying Service, Inc., 2025 WL 3030284 (Bankr. W.D. Mich. October 28, 2025).  View the opinion.

Facts

Prior to the chapter 11 filing, Adam Kendall was killed in a plane crash involving an airplane operated by the Debtor, McPhillips Flying Service, Inc. (the Debtor).  The heirs of Kendall (referred to as “Movants” in the opinion) filed a state court lawsuit for wrongful death and other causes of action against the Debtor.  In the course of discovery the Movants came to believe that the Debtor had violated terms of loans it had received from the United States government under the EIDL program.  This belief cause the Movants to file a Qui Tam complaint which alleged the Debtor violated the False Claims Act and had wrongfully used the loan proceeds, triggering liability for civil penalties.

Before the Debtor was served with the Qui Tam action and before the United States had determined whether to intervene, the Debtor filed a Chapter 11 petition and elected to proceed under Subchapter V (“Sub V”).  At the time of the filing, to be eligible as a small business debtor in a Sub V the debtor’s aggregate noncontingent liquidated debts could not exceed $3,424,000. 

By way of background, the Debtor operated an on-demand passenger flight and freight delivery service to and from Beaver Island, Michigan.  The Debtor had obtained a series of SBA loans under the EIDL program.  Each loan agreement signed by the Debtor acknowledged that the loaned funds could only be used for working capital and to the extent possible the Debtor must purchase American made goods.  Violation of that provision could result in treble damages and civil penalties.  A forensic accountant employed by the Movants opined that the Debtor violated the use provisions by buying fixed  assets.  The Qui Tam complaint  requested that a fine of between $14,000 and $28,000 be imposed against the Debtor for each misrepresentation and that other monetary penalties should accrue. The complaint alleged multiple misrepresentations and asserted other claims for damages.

The Department of Justice (DOJ) requested financial information from the Debtor, to which it responded prepetition.  Other than the DOJ investigation, the Debtor did not receive any communication from the SBA about any investigation into the alleged misapplication of funds.

The Debtor filed its Sub V Chapter 11 in July 2025.  It scheduled a total of $2,204,006 in secured and unsecured debt, which included secured debt to the SBA on the EIDL loans of about $966,000, $1 for the Kendall claim which it listed as contingent, unliquidated and disputed, and an unsecured claim listed in the name of Ryan Cobb, the AUSA assigned to the Qui Tam action in the amount of $0.0, scheduled for “notice only.”  The Debtor scheduled the alleged Qui Tam debt at $0.0 because on the petition date the action was still under seal.

Since the filing, both the Relator in the Qui Tam action (Movants’ agent) and the United States filed proofs of claims for damages, fines and penalties asserted in the Qui Tam action.  The Relator claim alleged damages exceeding $4,500,000 and the United States claim asserted damages of more than $3,000,000.  In addition to its secured claim the SBA asserted an unsecured claim based on the Qui Tam action for more than $1,500,000.

The Movants filed  a motion objecting to Sub V eligibility, asserting that the damages alleged in the Qui Tam action were noncontingent and liquidated.  When those debts were added to those scheduled by the Debtor, the Debtor would exceed the eligibility limit.  The Debtor opposed the motion, arguing that the Qui Tam action was in its very early stage and that none of the unscheduled debts had been assessed.  It asserted the debts, therefore, were contingent and unliquidated and should not count against the eligibility limit.

After briefing and argument, the Court ruled for the Debtor, concluding the unlisted debt was contingent and unliquidated.

Reasoning

In opposing the motion, the Debtor had relied in part on a chapter 13 case from the Sixth Circuit which concluded that eligibility issues are “normally” to be determined by reference “to the debtor’s schedules checking only to see if the schedules were made in good faith.”  In re Pearson, 773 F. 3d 751, 757 (6th Cir. 1985).  The Movants, to the contrary, argued that a more expansive inquiry was necessary in Sub V cases, which required examination of the status of claims as of the petition date.  The Court saw these arguments as arriving at the same place, favoring the Debtor. It stated the in this case where the Debtor had not even been served with the Quit Tam action, it had acted in good faith in scheduling the action “for notice only” and valuing the claim at $0.  However, Pearson also discussed potential exceptions to its rule, including cases where it appeared to a “legal certainty” that a claim was other than what the debtor said it was. In this circumstance, the Court determined it should review the record and make an “independent decision as to whether the claims at issue had been scheduled in good faith” and whether the claims were contingent or  unliquidated on the petition date.

Although the Bankruptcy Code does not define “contingent” or “unliquidated,” the Court found it well-settled that a contingent debt was one where a debtor need only pay it upon the occurrence of an extrinsic event which would trigger liability.  Examples were debts which might come due under a guarantee and claims which would arise after the alleged commission of a tort. It was also well-settled that a liquidated debt is one which can be determined at by a mathematical calculation based on sums in the known record; an unliquidated debt is the opposite and cannot be so calculated.

With these definitions in mind, the Court considered the debts which would arise in the Qui Tam action in addition to the principal owed on the SBA loans.  They were alleged penalties under the EIDL provisions for misuse of the loan proceeds or damages arising from the asserted violations of the False Claims Act based on the alleged misrepresentations by the Debtor in the EIDL process.  In light of the preliminary stage of the Qui Tam action which might impose both types of claims, the Court concluded that all the claims were contingent and unliquidated on the petition date.

Since no viable claims pushed the Debtor over the eligibility limit, the objection was overruled and the Debtor allowed to proceed in Subchapter V.

Author’s Comments

The Bankruptcy Court referred to using the same test for eligibility in Subchapter Vs that has been adopted in chapter 13s in several circuits, including the Sixth and Ninth: the general rule is that eligibility will be determined from the debtor’s schedules so long as they are filed in good faith.  Court-created exceptions to this rule exist but were inapplicable to this circumstance, but no exceptions were needed here.  The debts which must be counted for eligibility as a small business debtor as set forth in 11 U.S.C. § 101(51D) are only those which are noncontingent and liquidated.  Since the Qui Tam action on the petition date was no more than a series of allegations that the Debtor had committed unliquidated torts, the Court properly found the claims based on that action were contingent and unliquidated.

[The Commercial Finance Newsletter is written by an ad hoc group of layers in the Business Law Section of the California Lawyers Association.  This review was written by the Hon. Meredith Jury, U.S. Bankruptcy Judge, Central District of California (Ret.), a member of the ad hoc group.   The opinions contained herein are solely those of the author.]