Blog Posts
Bankruptcy
Corporate Subchapter V Debtors Beware: Creditors May Object to Dischargeability of Fraud and Other Claims, at Least in Some Jurisdictions
On June 7, 2022, the U.S. Court of Appeals for the Fourth Circuit (“4th Circuit”) held that the discharge exceptions in Subchapter V of Chapter 11 (enacted as part of the Small Business Reorganization Act (“SBRA”)) apply to both individual debtors and corporate debtors. Cantwell-Cleary Co., Inc. v. Cleary Packaging, LLC (In re Cleary Packaging, LLC), 36 F.4th 509 (4th Cir. 2022). The 4th Circuit’s decision reversed the bankruptcy court’s “nicely crafted opinion,” which held that the exceptions to dischargeability incorporated into the Subchapter V provisions of Chapter 11 applied only to individual debtors. The 4th Circuit’s decision is a big deal in the bankruptcy world because it is the first decision to hold that corporate Chapter 11 debtors are subject to all discharge exceptions under Section 523(a) of the Bankruptcy Code. In this case, the debt at issue was a $4.7 million judgment against the debtor for intentional interference with contracts and tortious interference with business relations. Section 523(a) of the Bankruptcy Code is the section relied upon by creditors objecting to certain types of debts, including for fraud, breach of fiduciary duty and willful and malicious injury. That section refers to dischargeability exceptions of an “individual debtor.” Section 1192, which applies only in Subchapter V cases, excepts from discharge debts “of the kind specified in section 523(a).” In holding that the Section 1192 dischargeability exception applies equally to corporate debtors, the 4th Circuit found that Section 1192 referred to “kinds” of debts as opposed to “kinds” of debtors. This decision is controlling precedent only in Maryland, Virginia, West Virginia, North Carolina and South Carolina. Bankruptcy courts in Idaho and Michigan have held that the discharge exceptions in Subchapter V apply only to individual debtors. It will take time before there are any potentially conflicting circuit decisions on this issue that could result in review by the U.S. Supreme Court. In the meantime, this author understands that certain groups may lobby Congress for a legislative fix to the 4th Circuit’s decision, which some believe will lead to unintended consequences at odds with the legislative history of Subchapter V. What are the potential unintended consequences? In Cantwell-Cleary, the National Association of Bankruptcy Trustees (“NABT”) filed a brief in support of appellee’s petition for rehearing en banc, which the 4th Circuit denied. In that brief, the NABT argued that the purpose of the SBRA was to “streamline the bankruptcy process by which small business debtors reorganize and rehabilitate their financial affairs.” The NABT argued, among other things, that by allowing claims under § 523(a) to proceed against corporate, small business debtors, Subchapter V cases will no longer proceed in a timely, cost-effective manner, nor will it help these companies remain in business. This may be true. For example, in a hypothetical case in which a creditor has a $4.7 million claim (that is not subject to a discharge exception), the debtor could confirm a plan (over the objection of creditors) that pays unsecured creditors only $100,000 if the debtor’s assets are not worth more than $100,000 and if the debtor does not generate more than $100,000 in projected disposable income over the plan term. That debtor could obtain a fresh financial start. By contrast, if that $4.7 million claim is nondischargeable, the debtor will be burdened with collection efforts and may not actually be able to survive. Indeed, the creditor with a nondischargeable claim ends up with significant leverage against the Subchapter V debtor trying to negotiate a consensual plan. Only time will tell whether other courts will follow the 4th Circuit and/or whether someone can convince Congress to clarify whether the discharge exceptions in Section 523(a) of the Bankruptcy Code apply to corporate Subchapter V debtors. For information on this topic, contact Stephen Metz.
August 31, 2022
Bankruptcy
Subchapter V Corner – Are Subchapter V Business Debtors at Risk to Fight Non-Dischargeability Creditor Complaints?
An interesting issue is percolating in the Fourth Circuit right now. This issue is whether, in a Subchapter V case, a creditor may successfully object to the dischargeability of certain debts of a non-individual debtor (as opposed to an individual debtor). The debts in question are the debts described in Section 523 of the Bankruptcy Code. Section 523 is titled “Exceptions to discharge” and describes the types of debts that are not dischargeable by “an individual debtor.” Section 523 includes certain tax debts, debts for fraud, debts for breach of fiduciary duty, debts for willful and malicious injury, and certain debts payable to a governmental unit. In the bankruptcy world, we’ve all been trained that Section 523 does not apply in cases filed by non-individual debtors. That’s because the preamble to Section 523 refers to debts of “an individual debtor.” When I first learned of this issue, I thought it was farfetched that a creditor could object to the dischargeability of the type of debts described in Section 523 in a bankruptcy case filed by an entity. However, if you look at the statutory provisions at issue here, there does appear to be some logic behind it. And because Subchapter V of Chapter 11 has only been around since February of 2020, the statutory provisions are brand new. Why is this important? I mentioned above that a case is pending in the Fourth Circuit on this issue. The case arises in the Cleary Packaging, LLC case (the “Debtor”), which was filed on February 7, 2021, in the U.S. Bankruptcy Court for the District of Maryland (the “Bankruptcy Court”). Prior to the filing, a creditor, Cantwell-Cleary Co., Inc. (the “Creditor”), obtained a large money judgment against the Debtor for intentional interference with contracts and tortious interference with business relations (the “Debt”). After the Debtor filed for bankruptcy, the Creditor objected to the dischargeability of the Debt under Section 523(a)(6) (willful and malicious injury). Ultimately, the Bankruptcy Court held that the Bankruptcy Code limits the application of Section 523 in Subchapter V cases to individual debtors. The Creditor obtained permission to pursue a direct appeal to the Fourth Circuit. Interestingly, the case caught the attention of the United States, which filed an amicus brief in support of reversal, citing several types of debts described in Section 523, including tax debts, certain fines and penalties and criminal restitution debts. Another group of nine interested parties also filed a separate amicus brief in support of reversal because of their interest in enforcing wage theft claims. The Fourth Circuit conducted an oral argument on March 10, 2022, and has not yet issued a decision. The Creditor and the amici curiae argue, among other things, that because Section 1192 of the Bankruptcy Code (which governs discharges in nonconsensual plans in Subchapter V cases) excepts from discharge any debt “of the kind specified in section 523(a) of this title,” and does not differentiate between individual and non-individual cases, it applies equally to both individual and nonindividual debtors. We shall see. For information on this topic, contact Stephen Metz.
April 27, 2022
Bankruptcy
Lenders Beware
WHEN IS A LENDER CROSSING THE LINE AND ENTERING LENDER LIABILITY WONDERLAND? A 2022 decision out of a bankruptcy court in Texas reminded lenders that an overly aggressive approach to a borrower can result in lender liability[1] and substantial damages. In this case, brought by a Chapter 7 trustee, the bankruptcy court concluded that the lender destroyed the debtor’s enterprise value and future as a going concern and ultimately drove the debtor out of business. The Court found that for the lender’s actions, the debtor would not have failed as a going concern and would not have had to file bankruptcy. As a result, the Court awarded $16,966,928 in damages for breach of contract and breach of the duty of good faith and fair dealing, fraudulent misrepresentation, contractual and business interference, and willful violation of the automatic stay. The lender unsuccessfully tried to argue that the debtor was dead on arrival. [1] As the bankruptcy court put it, “[l]ender liability” is a broad umbrella term often used to describe various theories through which a borrower (or its trustee in bankruptcy) seeks to impose liability (or a remedy of some sort) against a former lender in a lending relationship that has soured.” THE STORY BEHIND THE AWARD Bailey Tool & Manufacturing Company and its subsidiaries and affiliates (“Bailey”) was the debtor/borrower in this tragic story. Republic Business Credit, LLC (“Republic”) was the lender. Before filing bankruptcy, Bailey and Republic entered into a factoring arrangement and an asset-based loan facility in February 2015. Republic performed substantial diligence in late 2014 and early 2015 before entering into the agreements. During the due diligence process, Republic had identified several issues, including unpaid ad valorem taxes, stretched accounts payable, and a major customer (the Department of Defense) that paid on a milestone rather than progressive billing basis. Despite these issues, the underwriter viewed the proposed transaction as a “strong deal” and approved it. Four months after entering into the agreements, Republic refused to advance funds as expected, declared default and made payments to itself from Bailey’s lockbox under the factoring agreement to pay down the ABL (Asset Based Lending) facility. The Court found that Republic took complete and total control of Bailey’s cash. It controlled not only the collections through the lockbox and all disbursements too. All funds advanced from July 2015 forward were sent directly to vendors selected by Republic vendors and a payroll company for the payroll of employees selected by Republic. The Court held that the lender’s handling of disbursement was inconsistent with the parties’ agreements—specifically, the Factoring Agreements contemplated that Republic would “pay to Seller [Bailey] an Advance.” In September 2015, Republic stopped funding altogether. Republic also became involved in replacing management and otherwise micromanaging the Debtor. It forced the Debtor’s Chief Executive Officer to give the Republic a lien on his exempt homestead. THE DECISION In a meticulous 145-page decision, the Court analyzed the Republic’s conduct, including and highlighting numerous internal lender email communications produced in discovery and presented during the trial. The Court adopted the bankruptcy trustee’s theory of the case, i.e. that the lender: (i) refused to advance funds in good faith and in the manner promised almost immediately after the agreements were signed taking a stance that the businesses were in an “over-advanced” position, which was not a defined concept in the agreements and was problematic in light of several weeks of due diligence and awareness regarding certain slow-paying accounts and inventory status; (ii) charged fees, expenses, penalties and other items against “reserves” (contributing to the alleged “over-advanced” position), without any transparency; (iii) exercised excessive control over the businesses by controlling what vendors, employees, and expenses got paid and insisting on direct payments to them by the factoring company rather than funding to the businesses as contemplated by the underlying agreements (i.e., the argument being that this was an improper exertion of control; there were no amendments of documents or forbearance agreements to justify deviating from the underlying agreements). WHAT ACTION TO AVOID AS A LENDER This decision can now serve as a roadmap for borrowers to establish lender liability. In summary, the factors considered by the Court include: Taking over the business function and exercising business judgment – Without the requisite knowledge and experience, Republic approved payments to certain vendors and materials suppliers, reordered the sequence in which different products at Bailey were manufactured, and changed the manufacturing priorities from keeping long-term customers, to doing “quick-turn” projects; Controlling the workforce at Bailey through controlling the payroll and ordering who got paid and who did not and what types or classifications of employees could get paid; Directing vendors of Bailey to pay Republic instead of Bailey under the threat of litigation, destroying the goodwill that Bailey had built up with these vendors; Lack of transparency and misrepresentations as to why: (i) why it considered Bailey to be in default, (ii) the status of funds availability or lack thereof, (iii) application of funds collected and charging numerous fees and expenses. The conduct of the lender, in this case, appears egregious. Still, it is a reminder for lenders to closely review with counsel contractual remedies and exercise caution in implementing these remedies.
March 31, 2022
