The following is a case update written by Robert G. Harris (email@example.com), a partner in the Silicon Valley bankruptcy boutique, Binder & Malter, LLP, analyzing a recent decision of interest:
Addressing a matter of first impression in the Fifth Circuit, the United States Bankruptcy Court for the Western District of Texas (the “Court”) in Avion Industries, LLC v. GFS Indus., LLC, (In re GFS Industries, LLC) 2022 Bankr. LEXIS 3199; 2022 WL 16858009 (Bankr. W.D. Tex., San Antonio Div. November 10, 2022) recently dismissed an adversary proceeding under Federal Rule 12(b)(6), holding that “corporate debtors electing to proceed under Subchapter V of Chapter 11 are not subject to complaints to determine dischargeability pursuant to [section] 523(a)” and that section 727 is inapplicable in Subchapter V cases.
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GFS Industries, LLC (“GFS”) provided cleaning and environmental services to commercial tenants. GFS attempted to expand its business with funding from Merchant Cash Advances (“MCA”) by factoring its receivables. Cash flow proved insufficient to maintain operations. GFS filed bankruptcy under Subchapter V of title 11 on April 21, 2022.
Creditor Avion Funding LLC (“Avion”) had provided merchant cash advances. It claimed that GFS made material misrepresentations concerning whether a bankruptcy filing was imminent and failed to disclose the existence of other, more senior, MCA lenders from which GFS obtained funding.
Avion filed suit alleging in its complaint six causes of action under sections 523, 727 and 1141 from the same operative facts. GFS brought a motion to dismiss under Federal Rule 12(b)(6). The Court dismissed Avion’s adversary proceeding for the reasons set forth below.
The Court commenced its analysis by examining section 1192. The Court noted that section 1192 “does not contain a carve-out provision for non-individual debtors like the similarly drafted § 727(a)(1), which explicitly excludes non-individual debtors from discharge under Chapter 7.” The Court therefore started by holding that “[b]ecause § 1192 does not contain any provision that would preclude non-individual debtors from obtaining a discharge … the plain language of § 1192 grants a corporate Subchapter V debtor a discharge of debts provided the debtor meets the statutory requirements.”
The Court then turned to whether Avion’s adversary under section 523(a) was sustainable under the SBRA’s amendments to the Code. The Court noted that section 1192 provides for “a discharge of all debts provided in section 1141(d)(1)(A)” and excepts from discharge those debts that are “of the kind specified in § 523(a) of this title.” The Court ruled nevertheless that, while section 1192(2) on its face seeks to incorporate the list of debts that are deemed nondischargeable found in section 523(a), without regard for the character of the debtor, the preamble to section 523(a) contains overriding limiting language.
The Court made three key observations concerning the interplay between sections 1192 and 523: first, section 523(a) “unequivocally applies only to individuals [and] the language of § 1192(2) does not empower § 523(a) to cast a wider net than the text of § 523(a) permits.” Congress could, the Court noted, have included a phrase in section 1192(2) explicitly stating that the list found in section 523(a) applies to all debtors but did not. Second, the fact that Congress added section 1192 into section 523 demonstrates that Congress intended section 1192(2) to limit section 523 exceptions in Subchapter V to individuals only. Third, corporate debtors proceeding under Chapter 11 historically have been immune to dischargeability actions under section 523(a), and it is much more likely, and confirmed by the language used in Subchapter V, that Congress intended to expand, not discontinue, the principle that Chapter 11 corporate debtors are not subject to section 523(a) complaints to determine dischargeability. Because Subchapter V is merely a subchapter to the broader Chapter 11, this is the required result.
The Court therefore held that the statutory language, along with the broader Chapter 11 statutory scheme, mandated a holding that corporate debtors proceeding under Subchapter V cannot be made defendants in section 523 dischargeability actions. Avion’s claims under section523were dismissed for a lack of legal foundation
The Court distinguished New Venture Partnership v. JRB Consolidated, Inc. (In re JRB Consolidated, Inc.), 188 B.R. 373, 374 (Bankr. W.D. Tex. 1995), a case from the same district by another judge. The Court recognized the similarities between the language of sections 1228(a)(2) and 1192(2) but noted that because Chapter 12 is only available to a small and specific subset of debtors, Chapter 12 cases have unique considerations that are not present in a Chapter 11 case and that, in any event, Chapter 12’s incorporation of Section 523 is “broader” than the provisions referencing it in Subchapter V. The Court further noted that unlike chapter 12 cases, “Subchapter V is not its own chapter of bankruptcy, but rather is a subchapter of Chapter 11.”
The Court went on to cite with approval four other bankruptcy court decisions holding that the section 523(a) exceptions to discharge are applicable only to individuals, not corporations in Subchapter V. These cases are Jennings v. Lapeer Aviation, Inc. (In re LaPeer Aviation, Inc.), 2022 Bankr. LEXIS 1032, 2022 WL 1110072 (Bankr. E.D. Mich. Apr. 13, 2022); Catt v. Rtech Fabrications, LLC (In re Rtech Fabrications LLC), 635 B.R. 559 (Bankr. D. Idaho 2021); Cantwell-Cleary Co., Inc., v. Cleary Packaging (In re Cleary Packaging, LLC), 630 B.R. 466 (Bankr. D. Md. 2021), rev’d 36 F.4th 509 (4th Cir. 2022); and Gaske v. Satellite Rests. Inc. (In re Satellite Rests. Inc.), 626 B.R. 871 (Bankr. D. Md. 2021). The Court offered a comparison of the reasoning of the rulings from its sister courts, highlighting where concepts varied notwithstanding the uniform conclusion and result.
The Court then provided a detailed refutation of the main six arguments utilized by the Fourth Circuit in Cantwell-Cleary Co. Inc. v. Cleary Packaging, LLC (In re Cleary Packaging), 36 F. 4th 509 (4th Cir. 2022) and the Fourth Circuit’s ultimate determination that, as a matter of fairness and equity, “a small business debtor should not benefit from the discharge of debts incurred in circumstances of fraud, willful and malicious injury, and the other violations of public policy reflected in § 523(a)’s list of exceptions when that debtor is immune from the absolute priority rule.”
Finally, the Court ruled on the inapplicability of the other causes of action asserted to deny GFS a discharge. The Court said that “§1181(c) operates to make any subsections of § 1141(d) inapplicable, including § 1141(d)(3)(c), the vehicle used by Avion to import § 727 liability. There is no provision in § 1192 that would reinstate § 1141(d)’s applicability to the case.” The Court further found that “even if § 1141(d) was in play here, § 1141(d)(3)(C) is only one element of the broader provisions of § 1141(d)(3) and the other two elements are not met here.” Finally, “even if § 727(a) did apply to this case, it does not apply to entities by virtue of its language [as] Section 727(a)(1) explicitly excepts non-individual debtors from discharge under Chapter 7.”
The Court In re GFS Industries, LLC adds a well-reasoned opinion to a growing body of rulings by bankruptcy courts that section 523(a) does not apply to Subchapter V filings by entities. In re GFS Industries, LLC is a blueprint for a motion to dismiss any such filing. The disruption of Subchapter V cases resulting from In re Cleary Packaging will undoubtedly continue until Congress expressly clarifies the statute or the United States Supreme Court rules on an eventual but certain Circuit split.
PRACTICE POINT: Clerk’s offices before In re Cleary Packaging have been issuing notices in Subchapter V cases by entities without a deadline to file section 523 and 727 actions. Creditors in such cases have demanded the right to file such actions beyond the normal deadline for lack of notice, claiming confusion and prejudice notwithstanding the unambiguous requirement in Bankruptcy Rule 4007(c) to file not later than 60 days after the first date set for the § 341(a) Meeting of Creditors. Practitioners may wish to apply for a 523/727 action bar date, if one has not been set at the outset of a case, to mitigate the risk of a late, strategic 523 or 727 action.
This review was written by Robert G. Harris (firstname.lastname@example.org), a partner in the Silicon Valley bankruptcy boutique, Binder & Malter, LLP, and a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.