Business Law

Bankr. C.D. Cal. rules court approval not required for Small Business case to re-designate as Subchapter V

The following is an update analyzing a recent case of interest:

Summary

In re Progressive Solutions, Inc., 2020 Bankr. LEXIS 467 (Bankr. C.D. Cal. 2020) (“PSI”) is the first reported opinion addressing the Small Business Reorganization Act of 2019, Pub. L. No. 116-54 (2019) (the “SBRA” or the “Act”).  In PSI, Judge Scott Clarkson [https://calawyers.org/business-law/ilc-judicial-profile-series-united-states-bankruptcy-judge-scott-c-clarkson-central-district-of-california/] denied a Motion for Order Authorizing Amendment of Chapter 11 Petition to Elect Subchapter V (the “Motion to Amend”) and a related motion to confirm a new plan under the SBRA without prejudice.  The basis for the court’s ruling was that re-designation of a Small Business Case to one under Subchapter V is accomplished by amendment of the voluntary petition, and there is no legal requirement to obtain leave of court to amend under Federal Rule of Bankruptcy Procedure 1009 (“FRBP”).  Declining to adopt objections by the City of Oakland (the “City”) and the United States Trustee, the court found on the facts of this case that the Act could be applied retroactively to a small business case already pending on the SBRA’s effective date.  The court advised however that, if there is a re-designation by amendment to PSI’s voluntary petition, the parties may then object (see Federal Rule of Bankruptcy Procedure 1020(b)[i]), after which the court may consider PSI’seligibility for Subchapter V.

To read the published decision, click here.

Facts

PSI filed a Chapter 11 petition on November 21, 2018, electing to be treated as a “small business debtor” under the provisions of the Bankruptcy Code then in effect.

Prior to commencing its Chapter 11 case, PSI had appealed the District Court’s orders granting summary judgment[ii] in favor of the City in a lawsuit brought by PSI against the City alleging breach of contract and various business torts.  As of this writing, that appeal remains pending.  According to its preliminary Chapter 11 Status Report, PSI sought protection under Chapter 11 “to maintain its operations and implement a reorganization plan through the chapter 11 process after a stay pending appeal was denied and the [City] began aggressive collection actions” after the District Court’s July 11 and 13, 2018 awards aggregating $1,010,465.14 in fees and costs.  PSI sought to utilize the automatic stay in lieu of a supersedeas bond pending its appeals.

PSI’sbankruptcy schedules listed no secured debt and a total of only seven creditors with general unsecured claims.  Of these, five aggregated less than $21,000.  The remaining two were (i) the City’s $977,799 claim (scheduled as “unliquidated”) resulting from the attorneys’ fees and costs incurred in successfully defending PSI’s pre-petition action against the City; and (ii) the Berkeley Research Group’s $100,000 claim (also scheduled as “unliquidated” and “approximate”).

PSI filed an adversary proceeding attacking the City’s recently-recorded judgment lien as an avoidable preference, but that action was dismissed by a stipulation providing for the City to release its lien.  The City filed and maintained an unsecured proof of claim in the amount of $1,069,170, representing the above-referenced awards, plus interest.

PSI filed its initial Chapter 11 Plan and Disclosure Statement in May, 2019 and an amended plan on July 26, 2019.  PSI proposed to pay the City’s (and Berkeley Research Group’s) general unsecured claims a dividend of 50% (with the City’s claim being termed out over 9 years).  All other general unsecured creditors were classified separately into a “convenience class” to receive payment in full on the effective date of the amended plan.

The City objected to the plans and, on August 30, filed its own, competing Chapter 11 plan.

Among the confirmation objections raised by the City regarding PSI’s amended Plan were:

  • PSI’s apparent failure, in presenting a liquidation analysis for Section 1129(a)(7)’s “best interests” test, to account for accumulated post-petition cash reserves of $400,000 – an amount the City claimed would increase PSI’s Chapter 7 distribution to general unsecured creditors from $462,061 to $861,761, or a return of approximately 65% (as opposed to the 50% proposed by PSI’s amended Plan).
  • PSI’s owners’ proposed purchase of the entirety of PSI’s shares via a “new value” contribution of $30,000, with no opportunity for competing bids – all in violation of Section 1129’s “absolute priority rule” and the Supreme Court’s holding in Bank of America Nat’l Trust & Savings Ass’n v. 203 North LaSalle Street P’ship.
  • PSI’s disparate (50%) treatment of the City’s separately-classified unsecured claim with other “similarly situated” general unsecured creditor classes scheduled to receive 100% under the amended Plan – which treatment was, according to the City, discriminatory and therefore not “fair and equitable” under Section 1129(b) and which also violated the “equal treatment” mandate of Section 1123(a)(6).

The City’s competing plan proposed a sale of PSI’s equity to Ecker Capital for $100,000 and payment in full of all allowed general unsecured claims (including the City’s) over 3 years.

At a hearing held September 19, 2019, the court calendared a November 7 hearing to review the competing plans.

Thereafter, the City substituted in new counsel, withdrew its competing plan, and stipulated with PSIto a continuance of all confirmation matters in order “to engage in settlement discussions based on . . . changed circumstances in the case.”  The parties further agreed that the previously scheduled confirmation hearing be converted to a January 2020 status conference “to determine the course of proceedings at that time.”

PSIand the City then engaged in settlement discussions.  On January 3, PSI filed a status report requesting a further continuance of the status conference to February 20, 2020 and indicated its intention to:

  • amend its chapter 11 petition to elect “small business” provisions of subchapter V of chapter 11;
  • file a second amended plan to conform to the requirements of 11 U.S.C. § 1191(b); and
  • move to confirm its amended plan pursuant to 11 U.S.C. § 1191(b), effective February 19, 2020.[iii]

According to PSI, “[a]s § 1191(b) (effective February 19, 2020) of the SBRA authorizes confirmation without the necessity of an impaired consenting class and changes the requirements for fair and equitable treatment, [PSI] believes that the issues precluding confirmation at the September 19, 2019 hearing are eliminated.”

On January 30, as it had previously announced, PSI (i) sought leave to amend its petition; and (ii) filed its second amended Chapter 11 (Subchapter V) Plan and confirmation brief.  PSI’s second amended Chapter 11 Plan proposed to:

pay priority and administrative claims in full on or about the March 1, 2020 effective date of the Plan. All remaining general unsecured creditors [including the City] shall receive their pro rata share of Debtor’s net disposable income over 3 years from the effective date, estimated to be 17% of their claims.

The City and the United States Trustee each objected to PSI’s amendment request and to its second amended Chapter 11 Plan.

Decision

In the hearing on the Motion to Amend, counsel for the City argued that applying the SBRA to pending cases was impermissible.  The court raised as potentially instructive the case of In re Exide Technologies, Inc. Case No. 13-11482, January 9, 2020 [Dkt. # 5296], in which the Office of the United States Trustee had successfully argued that a 2017 change in law, increasing and changing the formula for U.S. Trustee Fees, applied to pending cases.  Turning to the SBRA itself, the court found that “[i]t was … conceded by all parties present at the hearing, that nowhere in the SBRA are there stated limitations to the application of the SBRA (including new preference recovery provisions) to pending cases.” 

Referencing Landgraf v. USI Film Products, 511 U.S. 244 (1994), a case discussed at length in comment below, the court examined whether the City, or any other creditor, had rights vested by rulings of the court, or other events occurring during the pendency of the present bankruptcy case, that would be disturbed by the re-designation of the case as a Subchapter V case. The court concluded, after hearing no examples from the parties or finding any such rights from examining the record and pleadings in this case, that it could find no such rights at issue.[iv]

The U.S. Trustee raised practical and procedural issues with re-designation including how to hold a timely Initial Debtor Interview, a Section 341(a) Meeting of Creditors that would include a Subchapter V Trustee, when the required Debtor Status Conference Report would be filed, and when the initial Status Conference for a Subchapter V case and 60-day Plan filing requirement would occur in a case already more than a year old.  The court responded that it could extend the deadlines for the status conference report and initial conference for cause (see 11 U.S.C. 1188(b), (c)), stating the “timing requirements could be reset in order to provide due process to all parties involved, unless vested rights of parties would be abridged or otherwise prejudiced” and dismissed the resetting of an initial debtor interview and Section 341(a) meeting as merely “redundant or awkward.”

The court therefore found “…no legal reason to restrict a pending Chapter 11 case to re-designate to a Subchapter V case, on the facts underlying the Motion” and declined to issue “…a blanket prohibitionof such re-designation by the Debtor.” 

The court then focused specifically on the language of FRBP 1009, stating that “[a] voluntary petition, list, schedule, or statement may be amended by the debtor as a matter of course at any time before the case is closed.”  The court concluded that “[t]o set a standard or precedent requiring a debtor to seek leave to amend a petition or schedule is improper, especially in light of Rule 1009 … there no legal requirement to have a court grant leave to amend the petition or schedules, and there are clear procedures for parties to later object to any amendments or designations (including a designation as a Subchapter V debtor within the new federal rules for the SBRA).”  The court therefore denied the Motion to Amend without prejudice as “procedurally infirm” and the motion to confirm a plan as premature.  

Authors’ Commentary

A good compilation of the basic analytic tools for whether federal statutes apply retroactively or only prospectively can be found cumulatively in Landgraf v. USI Film Products, 511 U.S. 244 (1994), Lindh v. Murphy, 521 U.S. 320 (1997), and Matthews v. Kidder, Peabody & Co., 161 F.3d 156 (3rd Cir. 1998).  Courts apply three tests in analyzing the intent of the statute as regards retroactivity: the first is whether there is in the text of the statute an “unambiguous directive” from Congress on the issue (either that it applies to existing cases or only prospectively).  If there is, the inquiry is at an end.  If not, then the next consideration is application of the normal rules of statutory construction to see if there is a discernible Congressional intent.  If neither of these analytic tools supply the answer, then courts must look to whether retroactive application would impair a party’s position by adversely affecting its existing rights, increasing or imposing liability for past conduct, or prescribing new duties for executed transactions.  If any of these three conditions exist, the statute should apply only prospectively.

In PSI, the court applied the SBRA retroactively, to a small business case pending on the Act’s effective date.  The court found no specific language directive from Congress in the Act on the issue either way.  BAPCPA, by contrast, includes specific directives that some (but not all) provisions were to be applied retroactively.  See Pub. L. 109-8, § 1501(b) (Apr. 20, 2005).  The court relied on the second and third tests from Landgraf to find that Congress intended retroactive application – as well as the finding of an absence of harm to the rights of the City or other creditors.  The court viewed the statute (probably correctly) as patently remedial, thus counseling Congressional intent for its immediate application.  And the court plainly believed that SBRA did not adversely affect material existing rights or duties.  The most detriment it had on any party, including the court and U.S. Trustee, was to create some novel procedural quirks which must be addressed, but the existence of these did not rise to the level of prejudice.  Thus, the third test also points to retroactive application. 

Perhaps it can be argued that the rights of the City have been prejudiced since it spent a lot of money fighting with PSIover PSI’s failed plan(s), filed its own plan and then withdrawn its plan.  It therefore appears, in connection with its stipulation with the debtor to continue the pending hearing on confirmation of the debtor plan, to foster settlement negotiations, only to have the debtor amend the petition to re-posture the case.  But the answer to that may be what the court has already noted:  any party can object to the amendment, and possible grounds for such an objection by the City are the unfairness of giving the debtor a do-over in the circumstances of this case and bad faith by the debtor in amending its petition under the circumstances.  FRBP 1009(a) expressly permits amendment of a petition.  Moreover, in doing so it does not on its face limit what in a petition can be amended.   Although far and away the most common amendments are to the Schedules, Statement of Financial Affairs or Exemptions, nothing in Rule proscribes the kind of amendment in PSI.  And FRBP 1020(a) permits a party to object to the small business designation of a petition. 

This last point raises some interesting issues.  In general, the standard for whether to allow a petition amendment is liberal.  However, in deciding whether to sustain an objection to an amendment, courts look a prejudice or the bad faith of the debtor as reasons for rejecting an amendment.  See, e.g., Arnold v. Gill (In re Arnold), 252 B.R. 778, 784-85 (BAP 9th Cir. 2000) (Citing to Magellanes v. Williams (In re Magellanes), 966 B.R. 253, 256 (BAP 9th Cir. 1988)).  Prejudice involves balancing prejudice to third parties from allowing amendment against prejudice to the debtor of disallowing it.   (Id.)  Is the prejudice test when applied to the retroactivity question the same as that applied to permitting an amendment, so that in cases where both tests are pertinent the resolution of the question with respect to retroactivity is dispositive of the whether to permit the amendment? 

In PSI, good faith and prejudice might both be important in any challenge to the amendment.  Is there cognizable and decisive prejudice to the City because it has spent so much time and money wrestling with the debtor and its plans, including going to the trouble of preparing and filing its own (albeit withdrawn) plan, only to be short-circuited by the amendment?  And it may well be that the debtor misled the City into agreeing to forego its competing plan and consenting to a continuance of the debtor’s plan confirmation hearing based on the idea that the time would be used to negotiate, only for the debtor to file an amendment to redesignate to Subchapter V.  If that is so, and the City is able to prove it in connection with an objection to the amendment, was that bad faith?  Would the prejudice and bad faith arguments not have been even more powerful had the City not withdrawn its plan and the debtor had sidelined the plan by filing the amendment since only the debtor can pursue a plan in Subchapter V?  

Lurking in all of this and awaiting development by case law is the question whether the retroactive/prospective issue is a whole case question or whether courts can and should decide the applicability of the SBRA only on a provision-by-provision basis based on the particular facts of the cases before them.  The latter is the approach in the more recent case of In re Moore Properties of Person County, LLC, 2020 WL 995544 at *2 (Bankr. M.D.N.C. Feb. 28, 2020). 

CARES Act Update

The CARES Act temporarily increases the debt limit to $7.5 million for cases filed before March 27, 2021. Section 1113(a)(3) of the CARES Act says that the new debt limit of 1113(a)(1) applies only to cases “commenced…on or after the date of enactment of this Act”.  This express provision against retroactivity for over-limit Chapter 11 pending on the date of the CARES Act shows that Congress is quite capable of prohibiting retroactivity when it chooses to do so and supports the reasoning set forth in in In re Progressive.

These materials were prepared by Robert G. Harris (rob@bindermalter.com), a partner in the Silicon Valley bankruptcy law firm, Binder & Malter, LLP, Michael Good (mgood@southbaylawfirm.com), Managing Principal of Southbay Law Firm, a Los Angeles based legal practice focused exclusively on commercial, municipal, and international insolvency matters, and Adam Lewis (ALewis@mofo.com), Senior Counsel in Morrison & Foerster LLP in San Francisco.


[i]  (b) Objecting to Designation.  … [T]he United States trustee or a party in interest may file an objection to the debtor’s statement under subdivision (a) no later than 30 days after the conclusion of the meeting of creditors held under §341(a) of the Code, or within 30 days after any amendment to the statement, whichever is later.

[ii] The District Court entered three separate orders on three separate dispositive motions by the City on: (i) December 12, 2017 (partial summary judgment); (ii) March 8, 2018 (summary judgment); and (iii) April 24, 2018 (summary judgment).  PSI appealed each of these.

[iii] It appears this request, and PSI’s announced intentions, may have come as a surprise to the City.  In its subsequently filed objection, the City complained that: “… notwithstanding [the City’s] efforts to meet and confer to resolve this two-party dispute, [PSI] has made zero effort to reach a consensual plan in this case. In fact, in the status report filed January 3, 2020 — in which [PSI] requested a continuance of the confirmation hearing — [PSI] admits that it has not met and conferred with [the City], but ‘intends to engage the City . . . in further discussions in due course’. [Dkt. 138, 2:18-19, 5:1-2.] [The City] holds more than 90% of the nonpriority unsecured claims filed against the estate. Why would [PSI] refuse to engage meaningfully with its one major creditor, and then rush to confirm its second amended Plan on only one week’s notice?”

[iv] The court did seem to imply that the City’s right to prosecute its competing plan might have been a vested right impacted by re-designation – had it not been withdrawn. 

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