The following is a case update written by Adam A. Lewis, Senior Counsel, Morrison & Foerster LLP, analyzing a recent decision of interest:
In Cantwell-Cleary Co., Inc. v. Cleary Packaging, LLC (In e Cleary Packaging, LLC),___ F.3d ___, 2022 WL 2032296 (4th Cir. June 7, 2022, No. 21-1981) (“Cleary”), reversing the Bankruptcy Court, the United States Fourth Circuit Court of Appeals (the “Fourth Circuit”) held that Bankruptcy Code (the “Code”) section 523(a)’s discharge exceptions as incorporated into Subchapter V by code section 1192(2) apply not to just individuals, but to entities as well.
Cleary can be found here.
Vincent Cleary (“Vincent”), one of the principals of a family-run company (the “Creditor”) became disenchanted. He left the Creditor and formed a new company (the “Debtor”) to operate in the same line of business, taking with him various employees subject to non-compete clauses, customer lists and other proprietary material of the Creditor. The Creditor sued the Debtor and Vincent in state court for various intentional business torts, wining a judgment of over $4 million.
Vincent thereupon filed a Chapter 11 case for the Debtor under Subchapter V (the “Case”), the Code provisions for a simpler, faster and less expensive reorganization for small businesses. The Debtor confirmed a plan that would pay the Creditor a pittance on its claim over many years but allowed Vincent to retain his equity in the Debtor. The Debtor was able to confirm this plan over the Creditor’s class-controlling negative vote even though the plan could not have satisfied the absolute priority rule in a regular Chapter 11 case. Such a plan is confirmable in a Subchapter V case if it proposes to pay the debtor’s “projected disposable” income for 3-5 years.
Relying on Code section 1192(2), the Creditor brought a timely action to object to the discharge of its claim under Code section 523(a)(6). Section 1192(2) excepts from discharge under a plan any debts “of the kind specified in section 523(a) of this title.” In turn, section 523(a)(6) prevents discharge of any debt “for willful and malicious injury by the debtor to another entity or to the property of another entity.” Granting the Debtor’s motion to dismiss the complaint, the Bankruptcy Court agreed with the Debtor that because by its terms section 523(a), which is incorporated by section 1192(2), applies only to “an individual debtor” and it therefore does not apply to entities such as the Debtor. However, the Bankruptcy Court granted the Creditor’s request to certify the matter for a direct appeal to the Fourth Circuit, which accepted the appeal. Crediting the Bankruptcy Court with an admirable opinion and calling the question a close one, the Fourth Circuit nevertheless reversed.
As background to its reasoning, the Fourth Circuit noted the disparity regarding the absolute priority rule between normal Chapter 11 cases and a Subchapter V case. In a standard Chapter 11, the debtor can confirm a plan over the dissent of an objecting class that is not being paid in full only if no junior class is faring better and equity does not retain ownership. As foreshadowed above, the only requirement for confirmation of a Subchapter V plan that violates the absolute priority/equity wipeout rule is that the plan provides for payment of all of the debtor’s “projected disposable income” to creditors for 3-5 years.
A Subchapter V “debtor” is a “person engaged in commercial or business activities.” And under the Code’s general definitions in section 101, a “person” includes both individuals and entities. Hence, both individuals and entities can file Subchapter V cases. Section 1192 of Subchapter V provides for the discharge of debts of a “debtor”, and as just noted, “debtor” means “person engaged in….” (Emphasis added.) Thus, absent any exceptions, a Subchapter V discharge would be available to both individual and entity debtors as “person[s].” But there are exceptions to discharge built into section 1192. The relevant one is found in 1192(2), which imports section 523(a)’s exceptions. But 523(a)’s introduction limits the discharge exceptions to “individuals.” Hence, the Debtor argued that 1192(2) only applies to individuals, not to entities such as the Debtor. The Bankruptcy Court agreed.
But the Fourth Circuit looked more closely and reached a different result. It explained that Section 1192(2) applies by its terms only to “debts of the kind” (emphasis added) specified in 523(a), focusing only on the nature of the debt and not, in contrast to the introduction to section 523(a) iterated above, on the nature of the debtor. It next noted that normally the more specific provision, in this case a provision that applies only in Subchapter V, governs over a more general one that applies more widely, such as section 523(a), which is not limited to a specific Chapter of the Code. This underscored the importance of the “of the kind” language of 1192(2) that contrasts with the “individual” language of 523(a). Furthermore, Congress knew how to deliberately identify different kinds of debtors when it wanted to. Chapter 7 and 13 discharges are only for “individuals”; and in Chapter 11, the Code expressly differentiates between individual and entity discharges in the kinds of debts that are discharged. Finally, the court observed that Chapter 11 distinguishes between discharges for individuals and entities but retains the absolute priority rule for both, whereas Subchapter V eliminates the rule for all debtors; hence, it makes sense that Subchapter V would treat both kinds of debtors the same in terms of discharges if they both benefit from suspension of the absolute priority rule. Thus, the Fourth Circuit concludes that although the statute could be more clear, the weight of analysis favors application of the 523(a) exceptions to all kinds of Subchapter V debtors.
The Fourth Circuit’s analysis is defensible, and probably right. But the cascade of technical statutory parsing could benefit from some more convincing analysis of what policy Congress was serving if the court’s conclusion is correct. Notwithstanding the textual survey of Code statutes by the Fourth Circuit, the reference to “individuals” in 523(a) is hard to ignore. The closest the court comes to underwriting its conclusion with a policy is its discussion of relief from the absolute priority rule all debtors get in Subchapter V. But the court does not explain why that should affect the scope of the discharge available to Subchapter V debtors except implicitly as a tit-for-tat exchange.
These materials were authored by Adam A. Lewis, Senior Counsel, Morrison & Foerster LLP, a member of the ad hoc group, with editorial assistance by Meredith Jury, (bankruptcy judge, C.D. Cal. (Ret.)), 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.