Filing Subchapter V Bankruptcy – Eligibility Criteria & Benefits

LA Small Business Bankruptcy: Determining Subchapter V Eligibility

Streamlined Business Reorganization Process – The Bankruptcy Code is not crystal clear about who is eligible to be a Sub-V debtor. Fortunately, Judge Elizabeth Stonghas recently written an opinion that one commentator has called “A compendium about eligibility for Subchapter V.” In re Christina Fama-Chiarizia, Chapter 11 Case No. 21-42341-ess (Bankr E.D.N.Y 2023). See Rochelle, Bill, Rochelle’s Daily Wire, September 26, 2023.

To be eligible for relief under Small Business Reorganization Eligibility Subchapter V, courts agree that:
(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 [D]ebtor.” In re Ikalowych, 629 B.R at 275 (citing 11 U.S.C. § 1182(1)(A))

As the In re Christina Fama-Chiariziacourt summed it up:
“Subchapter V is not for – or available to – everyone. It is tailored to the needs of small businesses and small business operators, who seek to address debt that arose from their business activity in a Chapter 11 bankruptcy case.”

In In reChristina Fama-Chiarizia, a minority owner (“Debtor”) of a construction company (and co-judgment debtor) Industrial Urban Corp. (“IUC”) filed for Subchapter V relief after the entry of a $3.3 million judgment against her and others and in favor of a company supplier (“Creditor”). Debtor was an individual and co-liable on a promissory note with IUC.

Creditor argued that Debtor was ineligible to be a Subchapter V debtor, because she was not, as of the date of the bankruptcy filing engaged in commercial or business activities, as required by Bankruptcy Code Section 1182(1)(A). Creditor argued that while Debtor owned 25% of IUC, she was not “engaged in commercial or business activities” because she had no involvement with the company for several years before the bankruptcy, and that IUC itself had not operated since prior to Debtor’s bankruptcy filing. Creditor observed that, other than its judgment (which itself comprised more than 50% of Debtor’s debts), Debtor’s bankruptcy schedules list only consumer debts.

Debtor responded by arguing Subchapter V does not require a debtor to be “actively” or “currently” engaged in commercial or business activity to reorganize under Subchapter V. She also pointed out Creditor’s judgment arises from a promissory note owed by IUC to the Creditor and that she was both a co-maker the note and a borrower. Therefore, she argued, her liability to Creditor arises from a business debt of her company. Moreover, Debtor noted that, since prior to the filing of her bankruptcy case, Debtor had been in separate litigation with her former IUC business associates.

Debt Restructuring Options under Sub-Chapter V – Debtor also argued that the Bankruptcy Code does not define “commercial or business activities,” such that it’s for the courts to decide what constitutes “commercial or business activities” on a case-by-case basis. She further argued that she satisfied each of the requirements to proceed as a Subchapter V debtor, because she is a “person;” her debts don’t exceed $7.5 million, more than fifty percent of her debt arises from a business debt. She also argued that other courts have found, Subchapter V does not require a debtor to be ‘currently’ engaged in business activity if the debt is tethered to business “legacy” debt.She argues “that whether the Debtor was making a profit, actively operating, or intending to operate in the future’ is not determinative of whether the Debtor was ‘engaged in commercial or business activity.

How Sub-Chapter V Affects Small Businesses in Los Angeles?

Debtor pointed to several courts that had held that a debtor need not be “currently” engaged in commercial or business activity to be eligible to reorganize under Subchapter V, including In re Bonert, 619 B.R. 248, 255 (Bankr. C.D. Cal. 2020) (In In re Bonert FLP Law Group defeated a motion brought by a dozen creditors who argued that the joint debtors were ineligible for Subchapter V because their commercial bakery had ceased operating prior to the commencement of the case. FLP Law Group is proud to have been one of the first law firms in the country to have successfully litigated a challenge to Subchapter V eligibility.) You can read more about this case and other successful outcomes in our Case Results section.

Sub-Chapter V vs. Traditional Chapter 11 – For its part, Creditor noted that several courts have held that the existence of residual business debt alone is not sufficient to qualify a debtor for Subchapter V.” CitingIn re RS Air, LLC, 638 B.R. 403, 410 (9th Cir. B.A.P. 2022); In re Ikalowych, 629 B.R. at 282; In re Thurmon, 625 B.R. 417, 423 (Bankr. W.D. Missouri 2020).

Debtor added that she was eligible for Subchapter V because she is currently engaging in renting to a tenant a studio apartment that was a separate portion of her two family home, “dealing with restructuring legacy debt” (i.e. Creditor’s judgment), and actively pursuing counterclaims as a shareholder in IUC against her former business associates.

Qualifications for Sub-Chapter V Bankruptcy – Judge Stong addressed the “legacy debt” by citing with approval In re Blue, 630 B.R. 179, 191 (Bankr. M.D. North Carolina 2021), in which the court found:

“Debtor intends to use subchapter V to address both defunct and non-defunct commercial and business activities, and the more straightforward interpretation of § 1182(1)(A) does not require a connection of debts to current business activities. Nothing in the statute requires that there be a nexus between the qualifying debts and the Debtor’s current business or commercial activities. Moreover, such an interpretation could, for example, disqualify meritorious small businesses from the remedial purposes of subchapter V simply by having significant debts from former operations.”

“Debtor intends to use subchapter V to address both defunct and non-defunct commercial and business activities, and the more straightforward interpretation of§ 1182(1)(A) does not require a connection of debts to current business activities. Nothing in the statute requires that there be a nexus between the qualifying debts and the Debtor’s current business or commercial activities. Moreover, such an interpretation could, for example, disqualify meritorious small businesses from the remedial purposes of subchapter V simply by having significant debts from former operations.”

Navigating Sub-Chapter V Bankruptcy Laws Judge Stong proceeded to analyze each of the Subchapter V eligibility requirements in turn:

What is a “person”? In In re Fama-Chiarizia, no one disputed that Debtor was a “person” within the meaning of the statute, and Judge Stong so found.

Whether Debtor’s debts exceeded $7.5 million.
In In re Fama-Chiarizia, however, the Court had not trouble finding that Debtor was within the Subchapter V debt limits.

To be sure, the debt limitation for Subchapter V eligibility is more nuanced than it often appears, and the debt limitation was not at issue in In re Fama-Chiarizia. The $7.5 million limit only applies to debts that are:

“. . . non contingent liquidated secured and unsecured debts as of the date of the filing of the petition or the date of the order for relief in an amount not more than $7,500,000 (excluding debts owed to 1 or more affiliates or insiders) . . ..”
Contingent debts (usually guaranties where the principal obligor is not in default) and unliquidated debts (like most tort claims) are not included in the calculation. Practioners, therefore, should not assume that a Debtor is ineligible for Subchapter V just because at first blush the debts appear to exceed the statutory maximum.

What does it mean to be “engaged in commercial or business activities”?

Much has been written about whether an individual debtor, say one who has personally guarantied the business obligations of an LLC or corporation is “engaged in commercial or business activities” for the purpose of Subchapter V eligibility. After sifting through the relevant case law, Judge Stong concluded:

“This Court agrees with the thoroughly analyzed and well-reasoned decisions of bankruptcy courts within and outside this Circuit that have found that a debtor’s eligibility to reorganize under Subchapter V turns on whether the debtor is “engaged in” commercial or business activities as of the date that the debtor seeks to invoke the protections and opportunities of Subchapter V – here, the Petition Date. Put another way, the Court finds that the relevant date to consider is not some date in the past, but the date that the debtor seeks to pursue a restructuring under Subchapter V – again, here, the Petition Date.”

Judge Stong then turned to the issue of what amounts to “commercial or business activities” for purposes of Subchapter V. To conduct its analysis, the Count, relied in part on FLP Law Group’s In re Bonert case:

“In In re Bonert, the bankruptcy court similarly considered an issue that arose soon after the SBRA became effective. There, the court considered ‘whether the Debtors should be permitted to amend their Chapter 11 petition to elect treatment under the newly-enacted Subchapter V of Chapter 11.’[Citations] As the court explained, the Debtors initially did not elect to proceed under Subchapter V because “[a]s of the Petition Date, the Debtors were not operating a business, and therefore did not believe that the ‘small business.’” [Citations]

“Citing the bankruptcy court’s decision in In re Wright, the court observed that the debtors sought re-designation in good faith, and concluded that “the re-designation is appropriate since the majority of the Debtors’ liabilities are business debts stemming from their prior operation of Bonert’s Inc., a bakery” and that “they were not motivated by gamesmanship, but rather by the Debtors’ understanding of the facts and the law as they existed at the time of each designation.’ [Citiations]

Holding that, as in In re Blue, 60 B.R. at 191, no nexus was necessary between the debts in the bankruptcy case and the business of the Debtor as of the petition date (here, engaging in litigation related to the no-longer-operating IUC and the renting out of a studio apartment attached to Debtor’s home), Judge Stong held that Debtor had met the “engaged in commercial or business activities” requirement of Subchapter V.

Conclusion

In re Fama-Chiarizia is but the most recent case in which a court looked to the “totality of the circumstances” to determine Subchapter V eligibility. Judge Stong held that:

“The court may look to the facts and circumstances of the debtor’s particular situation, including what led to the debtor’s bankruptcy filing, the activities in which the debtor is engaged as of the petition date, and how the debtor plans to proceed in the bankruptcy case to marshal its assets and address its debts.”

Judge Stong agrees “with the substantial majority of courts that have found that a debtor may be eligible to reorganize under Subchapter V when it seeks to address residual business debt, and to marshal residual business assets.” Specifically, she writes, “evaluating, asserting, pursuing, and defending litigation claims . . . can still . . . satisfy Section 1182(1)(A)’s requirement of ‘commercial or business activities.’”