The following is a case update written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., ret.), analyzing a recent decision of interest:
A Bankruptcy Court for the District of Colorado, ruling on a case of first impression in the Tenth Circuit, determined that an individual was eligible to be a debtor in a Small Business Reorganization Act of 2019 (SBRA) Subchapter V chapter 11 case despite the fact that he was a wage earning employee of a company which was unrelated to the debtor’s failed corporate business on the petition date. In re Ikalowych, 2021 WL 1433241 (Bankr. D. Colo. 4/15/21)
To view the Memorandum Opinion, click here.
Debtor John Matthew Ikalowych has been an entrepreneur for years. He wholly owns a limited liability company, JMI Management, LLC, which, in his words, he uses as a “pass-through” entity for certain business interests. JMI, in turn, owns a 30 percent interest in a second LLC, Lyceum Hailco, LLC (Hailco), which operated an automotive hail repair business. The debtor worked for and managed Hailco until it experienced financial difficulties shortly before the debtor filed chapter 11. Hailco ceased business and surrendered its assets to its secured creditor, Sunflower Bank. Hailco’s failure triggered the debtor’s bankruptcy filing because he had guaranteed most of its debt. Its failure also caused the debtor to seek employment to make a living, although he did fulfill his management duties for Hailco by doing some “wind down” work both before and after his bankruptcy filing.
When the debtor filed chapter 11 on November 20, 2020, he made a Subchapter V election (the Election) in Section 13 of the petition, right after he had checked the “no” box in Section 12, which had inquired whether he was a full or part-time sole proprietor. Later in the petition he characterized his debts as primarily business debts. On February 5, 2021, the debtor filed his plan of reorganization.
The United States Trustee (UST) objected to the Election, asserting that the debtor was ineligible because he was not “engaged in commercial or business activities” within the meaning of section 1182(1)(A). Creditor Sunflower Bank, owed substantial debt based on debtor’s guarantees of Hailco obligations, joined the objection. The Subchapter V Trustee sided with the debtor on the Election dispute. The bankruptcy court (the Court) held two non-evidentiary hearings and one evidentiary hearing and thereafter issued a Memorandum Opinion, ruling that the debtor was eligible to be in Subchapter V.
The Court made factual findings regarding the debtor’s work for Hailco, his interest in JMI which owned 30% of Hailco and also had engaged from time to time in other business ventures, and the fact that neither Hailco nor JMI had been dissolved. It noted the undisputed fact that on the petition date Hailco was out of business and the debtor was an employee of an unrelated commercial insurance business. It also found that the debtor’s schedules identified fifteen creditors with aggregate debt of less than $7.5M (under the SBRA debt limit as modified by the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act) which temporarily expanded the definition of a small business debtor to include debt up to $7.5M, now extended to March 27, 2022). The vast majority of the debt was related to the Hailco guarantees.
The Court then turned to the definition of debtor in Subchapter V cases found in section 1182(1)(A) and concluded that the statutory text lists four discrete requirements for Subchapter V eligibility: (1) the debtor must be a “person”; (2) the debtor’s aggregate debt as of the Petition Date must not exceed $7,500,000; (3) the debtor must be “engaged in commercial or business activities”; and (4) 50% or more of the debtor’s debt must have arisen from the “commercial or business activities of the debtor.” If the debtor met those four requirements, then he was eligible to be a Subchapter V debtor.
Three of the four criteria were easily disposed of: (1) “person” is defined in section 101(41) to include an individual; (2) the aggregate debt was less than $7,500,000, even if the contingent and unliquidated debt was included, a fact which was not contested by either the UST or Sunflower Bank; and (4) the debt based on the Hailco guarantees was from business activities of the debtor and far exceeded 50% of his total debt. The court then turned to the definition of what was “commercial or business activities” and whether the debtor was engaged in such.
The Court undertook a lengthy statutory interpretation exercise (its word) to arrive at the conclusion that this debtor was engaged in the necessary commercial or business activity. It analyzed the textual context of the words in the statute, considered statutory analogs regarding other federal legislation which used the terms, and consulted with dictionary definitions. It concluded that Congress meant to terms to be “exceedingly” broadly construed. The most challenging part of its analysis, however, was whether the debtor was “engaged” in the activities as of the petition date, the appropriate temporal requirement. It employed a “totality of the circumstances test to make the call.” Based on the debtor’s direct ownership of JMI, his indirect ownership of Hailco, and the fact that neither was dissolved and both had been conducting business activities within close proximity to the petition date, the Court concluded the debtor was sufficiently engaged in business to qualify. In a broad brush, the Court also found that debtor’s employment as a wage earner selling commercial insurance products also would constitute a commercial or business activity and added that conclusion to its totality test.
This decision pushes the limits of debtor eligibility for Subchapter V when the debtor is an employee of a third party, not operating a business, on the petition date. The proximity of Hailco’s failure to the petition date and the fact that the most of the debtor’s debt arose from Hailco guarantees seem the strongest points in favor of finding the debtor eligible. I question whether the continued “operation” of JMI as a pass-through entity, without itself actually being engaged in any business activity within five years of the petition date, should contribute to the analysis at all. And I doubt that the Court’s conclusion that the debtor’s employment by a commercial insurance company, selling its products, is even close to what Congress intended for a small business bankruptcy with expedited proceedings. The Court admitted it was making a close call and I agree. What is missing from the analysis is the concept of reorganization of a going concern, which certainly was a primary purpose of SBRA – i.e., to keep small businesses operating by utilizing a less costly and time-consuming chapter 11 procedure. That consideration seemed to have no weight with this court.
This opinion is definitely worth a read by chapter 11 practitioners, however, especially when faced with a client not actually doing business on the petition date. It provides a roadmap of considerations and arguments which might be persuasive in convincing a court to find the debtor eligible for the streamlined procedures available under Subchapter V.
This submission was written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., ret.) a member of the ad hoc group, with editorial contributions from Monique D. Jewett-Brewster, a shareholder with Hopkins & Carley, ALC, a member of the ad hoc group and past chair of the CLA Business Law Section. 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.