In this article, I examine whether a creditor can oppose the discharge of an entity’s debt when the debtor elects to proceed under Subchapter V of chapter 11.
In a bankruptcy case, creditors can file a complaint in the bankruptcy court seeking to have debts declared non-dischargeable under 11 U.S.C. § 523. Reasons include false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor’s or an insider’s financial condition; false financial statements; fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny, or; willful or malicious injury. There are a number of other reasons but these are the most common, in my experience.
There is a limitation in § 523 on who can be sued – specifically, “a discharge . . . does not discharge an individual from any debt . . ..” 11 U.S.C. § 523(a) (emphasis added). Entities cannot be sued under § 523 in a traditional chapter 11 bankruptcy case.
In 2019, Congress passed the Small Business Reorganization Act creating a new chapter 11 bankruptcy known as Subchapter V codified at 11 U.S.C. § 1181 et seq. Subchapter V was created for persons engaged in commercial or business activities that have aggregate noncontingent liquidated secured and unsecured debts in an amount not more than $7.5 million. Originally, the debt limit was $2,725,625.00 but was temporarily increased to $7.5 million by the Coronavirus Aid, Relief, and Economic Security Act. In March 2022, the debt limit reverted to $2,725,625.00 but in June 2022, Congress increased the debt limit to $7.5 million again through June 21, 2024. Subchapter V is intended to be the faster, easier, and cheaper version of chapter 11 bankruptcy, allowing small businesses to reorganize like mid-size and large companies.
Discharge of debts under Subchapter V is governed by 11 U.S.C.§ 1192(2) which provides: “If the plan of the debtor is confirmed … the court shall grant the debtor a discharge of all debts … except any debt … of the kind specified in section 523(a) of this title.” Section 523(a) is limited to “individuals” but § 1192(2) applies to “debtors” which, under bankruptcy code, includes both individuals and corporations. In interpreting the language in §§523(a) and 1192 and the definition of “debtor,” the 4th Circuit Court of Appeals held that a creditor can oppose the discharge of a corporate Subchapter V debtor. In re Cleary Packaging, LLC, 2022 WL 2032296 (4th Cir. June 7, 2022). In Cleary Packaging, a creditor obtained a $4.0 million judgment against the debtor who subsequently filed a Subchapter V bankruptcy. The debtor proposed paying the judgment creditor 2.98% of the judgment with the remainder being discharged. The creditor objected to the debtor’s discharge under §§ 1192 and 523(a)(6) for willful and malicious injury. The bankruptcy court dismissed the case holding that the discharge exceptions in § 523(a) do not apply to corporate debtors. On appeal, the 4th Circuit concluded that in Subchapter V cases where the debtor does not confirm a consensual plan, the discharge exceptions in § 523(a) apply to both individual and corporate debtors.
This is a significant shift from traditional chapter 11 cases where corporate debtor’s do not face actions from creditors opposing the discharge of debt. To date, the 4th Circuit is the only appellate court to decide the issue of whether creditors can file actions opposing a corporate debtor’s discharge. Four other bankruptcy courts, like the Cleary Packaging bankruptcy court, have held that exceptions to discharge are applicable to individuals only and not to corporations under Subchapter V. Jennings v. Lapeer Aviation, Inc. (In re LaPeer Aviation, Inc.), Adv. No. 22-03002, 2022 Bankr. LEXIS 1032, 2022 WL 1110072 (Bankr. E.D. Mich. Apr. 13, 2022); Catt v. Rtech Fabrications, LLC (In re Rtech Fabrications LLC), 635 B.R. 559 (Bankr. D. Idaho 2021);; Gaske v. Satellite Rests. Inc. (In re Satellite Rests. Inc.), 626 B.R. 871 (Bankr. D. Md. 2021); Avion Funding, LLC v. GFS Indus., LLC (In re GFS Indus., LLC), 647 B.R. 337, 346 (Bankr. W.D. Tex. 2022). All four bankruptcy courts granted motions to dismiss under Fed. R. Bankr. P. 12(b)(6) for failure to state a claim upon which relief can be granted. On February 3, 2023, the bankruptcy court in Avion Funding granted a direct appeal to the 5th Circuit.
I am aware of five complaints opposing the discharge of a Subchapter V debtor’s debt being filed in Colorado although there could be others. Of the five, one debtor’s case was converted to chapter 7 ending the adversary proceeding given the limitations in § 523(a). The other four are currently being held in abeyance although the debtors filed answers and not motions to dismiss the cases. I am curious to see how the bankruptcy court in Colorado will address this issue and practitioners and Subchapter V debtors and creditors should be aware of the possibility of having debts declared non-dischargeable and of the strict deadlines for filing such actions.
