In re Samurai Martial Sports, Inc. (Bankr. S.D. Texas 2022)

The following is a case update written by Robert G. Harris (rob@bindermalter.com), a partner in the Silicon Valley bankruptcy boutique, Binder & Malter, LLP, analyzing a recent decision of interest:

SUMMARY

The Bankruptcy Court for the Southern District of Texas (the “Court”) recently denied a debtor’s motion to modify a confirmed subchapter V plan of reorganization under section 1193(c) seeking to pause payments for three months and cure a default over the plan’s term.  The Court denied the motion, finding that the debtor’s intentional failure to make a payment was not the result of unforeseen circumstances rendering the Plan unworkable as required by Section 1191(c).  The Court further found the amended plan would not have been confirmable under Section 1191(b) on numerous grounds, including the absence of a reasonable likelihood that debtor would be able to make all payments after modification as required by Section 1191(c)(3)(A).  In re Samurai Martial Sports, Inc. (Bankr. S.D. Texas 2022) 2022 Bankr. LEXIS 2683, 2022 WL 4540962. 

To view the opinion, click here. 

FACTS

The Debtor operates a sports complex and physical fitness facility in Houston, Texas that provides martial arts training, hosts summer camps, runs after school programs, and has fitness activities for both children and adults. 

Two of the facility’s air conditioning units failed in late June, 2022, some two months after confirmation of Debtor’s Fourth Amended Plan of Reorganization for Small Business Under Chapter 11 (the “Plan”).  The Debtor claimed that the failure of the HVAC units caused a decline in business and revenue as many clients ceased coming to class and paying during the hot Texas summer. 

The Plan provided for monthly payments and the deposit of net cash flow into an emergency reserve fund (the “Fund”).  The Debtor defaulted on both its June and July, 2022 Plan payments, curing the first after the Subchapter V trustee’s notice of default.  The Debtor admitted that it had intentionally failed to make the June Plan payment.  The Debtor also neglected to deposit its net revenues into the Fund.  When pressed on why net revenue had not been deposited, the Debtor’s principal testified that he didn’t know why the payments were not made or know where the funds had been expended.   

The Court found that the Debtor generated revenue in June, 2022 in excess of its projections and in fact had sufficient funds on hand to make the July Plan payment and to pay, at least in part, for repair of the HVAC units.

PROCEDURE

The Debtor commenced the case on July 2, 2021, by filing a voluntary Chapter 11 petition and electing therein to proceed under Subchapter V.  The Plan was confirmed on March 3, 2022.

On June 16, 2022, Trustee filed a Notice of Plan Default (the “June Default”).  On June 29, 2022, Debtor made its June Plan payment.  On July 16, 2022, Trustee filed a Second Notice of Plan Default (the “July Default” and together with the June Default, the “Defaults”). 

On August 2, 2022, Debtor filed an Emergency Motion to Modify Debtors Fourth Amended Plan of Reorganization for Small Business Under Chapter 11″ (the “Motion to Modify”), referring to a modified plan (the “Modification”).  The Debtor sought to retroactively cure the Defaults, pause Plan payments for the months of July-September, resume payments beginning October 1, 2022, and make up the arrearages owed to creditor BankUnited over the course of 45 months

The Court denied the Motion to Modify.   

REASONING

The Motion to Modify was brought under Section 1193(c).  This Section provides in pertinent part that “[i] a plan has been confirmed under section 1191(b) … the debtor may modify the plan at any time within … [the plan term] … but may not modify the plan so that the plan as modified fails to meet the requirements of section 1191(b)….The plan as modified under this subsection becomes the plan only if circumstances warrant such modification and the court, after notice and a hearing, confirms such plan, as modified, under section 1191(b).” 

There is no case law as to what “circumstances warrant such modification” as used on Section 1193(c) means.  The same language however appears in Section 1127(b).  The Court therefore applied the rule of statutory construction that similar statutes should be interpreted similarly and analyzed case authority under Section 1127(b).  

Citing Collier on Bankruptcy, the Court held that to modification of a confirmed plan of reorganization under § 1193(c) must be warranted under the circumstances, and that in assessing whether modification is warranted under § 1193(c) the debtor must show that the events which gave rise to the modification were the result of an unforeseen circumstance that rendered the confirmed plan to be unworkable. Whether circumstances are unforeseen or render the plan unworkable are fact determinations to be made by the Court. In analyzing whether circumstances were unforeseen, a debtor’s good faith and business judgment are relevant.  While there seems to be a split of authority, the Court reasoned that debtors who undertake, in good faith, reasonable business decisions that ultimately render the plan unworkable should not automatically be precluded from modification even if the results of their decisions were “foreseeable” as a possible outcome.

Creditor BankUnited objected to the Modification Motion on the ground that the Debtor knew or should have known that the HVAC units would fail.  The Court overruled this objection.  The Court however found sua sponte that the Modification was not warranted under § 1193(c) because: (a) Debtor intentionally failed to remit the June 2022 Plan payment to the Trustee for disbursement, (b) Debtor inexplicably failed to escrow net profits for the Fund, and (c) Debtor failed to show that the Defaults were the result of unforeseen circumstances.

The Debtor’s choice not to make the June 2022 Plan payment was the primary basis for finding that the Modification was not warranted.  The Court’s analysis of this conduct was instructive: Debtor’s “… intentional failure to adhere to the terms of the Plan can only be attributed to Debtor’s deliberate and conscious decision to disregard this Court’s order directing Debtor to make all payments under the Plan, and not any unforeseen circumstance rendering the Plan unworkable. It is axiomatic to say that intentionally withholding Plan payments constitutes bad faith and poor business judgment.”  The Court later stated plainly the consequences of purposefully refusing to make a plan payment: “Debtor’s June Default was of Debtor’s own doing, it was done in bad faith, and cannot be cured under any circumstance.”     

The second ground for denial was Debtor’s failure to escrow net profits for the emergency Fund and its admission that it did not know why the payments were not made or where the funds had been expended, coupled with an offer of only vague assurances that the Fund would be funded going forward .  The Court ruled that, in light of these uncertainties, the Debtor had not met its burden to prove it had committed all projected disposable income to the Plan as required by Section 1191(c)(2)(A).  

Finally, because the Debtor had sufficient funds to make the July, 2022 payment, the Court ruled that the failure to pay according to the terms of the Plan could not be the result of unforeseen circumstances rendering the Plan unworkable. 

Because plan modification under Section 1193(c) requires proof that the plan can be confirmed under section 1191(b), the Court engaged in an extensive analysis of the Modification under Sections 1191(b) and 1129(a).  The Court found numerous deficiencies and violations which would have prevented a non-consensual confirmation: first, the Debtor failed to provide an updated liquidation analysis or adequate projections of future income and expenses, violating Sections 1190(1)(B) and 1190(1)(C) respectively, precluding Debtor from proving that that the best interest of creditors test of Section 1129(a)(7)(A)(ii) had been met.  Second, the Debtor’s intentional failure to timely remit the June 2022 Plan payment was found to have been in bad faith and in violation of Section 1129(a)(3).  Third, the Debtor made no effort to re-ballot and solicit new acceptances.

AUTHOR’S COMMENTS

Section 1193(c) allows a debtor to modify a plan confirmed under section 1191(b) at any time during the term of the plan.  This may well be the second most-powerful provision in the Small Business Reorganization Act of 2019 (behind redefinition of the term “fair and equitable”), allowing blameless debtors who seek prompt relief to modify their failed plans.  Counsel who monitor cases closely and keep clients properly advised can limit the risks of default and liquidation by the Subchapter V trustee or conversion to Chapter 7.  The only remarkable thing is that it has taken 32 months for a case to be published addressing the substantive requirements for modification after substantial consummation under Section 1193(c).

This case offers one further lesson: balloting may well be required to obtain approval of a plan modification.  It’s not at all clear that Bankruptcy Rule 3019(a) applies in Subchapter V cases even to non-material modifications.  As the Court in In re Samurai Martial Arts noted, even if the amendment will ultimately be nonconsensual and require no creditor approval, debtors have an obligation to solicit ballots because, unless a debtor makes a good faith effort to ballot, the court will not in a position of being unable to ascertain if the plan can be confirmed under Section 1191(a) or 1191(b). 

This review was written by Robert G. Harris (rob@bindermalter.com), 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.