Judge Gargotta Nixes Non-Dischargeability Claim Against Corporate SubV Debtor

 Distinguishing a precedent from his own district and disagreeing with the Fourth Circuit, Judge Craig Gargotta has ruled that non-dischargeability only applies to human Subchapter V debtors. Adv. No. 22-5052, Avion Funding, LLC v. GFS Industries, LLC (Bankr. W.D. Tex. 11/10/2022).  The decision can be found here. The decision was especially sweet for me personally because the case it distinguished, New Venture Partnership v. JRB Consolidated, Inc. (In re JRB Consolidated, Inc.), 188 B.R. 373, 374 (Bankr. W.D. Tex. 1995), was one that I lost and always thought was wrongly decided. 

NCBJ 2022: Five Secrets to a Magical Sub-V

Judge Catherine McEwen (Bankr. M.D. Fla.) and panelists David Mawhinney (Bowditch, Framingham, Mass.), Amy Denton Mayer (Stichter Riedel Blain Postler, PA, Tampa, Fl) and Kirk Burkley (Bernstein-Burkley, P.C., Pittsburgh, PA) donned their wizard's hats to present 5 Secrets to a Magical Sub-V. Both David and Amy serve as Subchapter V trustees and represent SubV debtors, while Kirk offered the creditors' viewpoint. Their program covered five areas of Subchapter V law and practice.

Another Alex Jones Entity Seeks Bankruptcy Protection

 Faced with pending trials to establish liability for defamation, another Alex Jones entity has decided to test the waters of bankruptcy. On Friday July 29, 2022, Free Speech Systems, LLC, the company which actually produces the Alex Jones Show and his other programming, filed a petition under Subchapter V of Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the Southern District of Texas, Victoria Division. Case No. 22-60043.  In April, three minor entities within the Jones organization filed bankruptcy in an attempt to channel liability away from Jones and Free Speech Solutions. Those cases met substantial resistance and were voluntarily dismissed. 

The Alex Jones Bankruptcy Gambit

 In a widely misunderstood move, Alex Jones and his legal team have put three of his entities that own intellectual property assets into SubChapter V of Chapter 11. The move, if successful, will protect the domain name, infowars.com, and will delay entry of judgments against Jones personally. The move involves apparent forum shopping and clever use of SubChapter V. The cases are jointly administered under Case. No. 22-60020 in the Southern District of Texas, Victoria Division.

Senior Care Centers Cases Illustrate Fine Line Between Complex and Small Business Cases

 “One pill makes you larger
And one pill makes you small….”
— “White Rabbit” by Jefferson Airplane

Senior Care Centers Inc., a chain of skilled nursing facilities, accomplished the feat of filing once as a complex chapter 11 case in 2018 (“First Case”) and then re-filing as a small business debtor in 2021 (“Second Case”). This success can be attributed to its ability to shed debt in its First Case, as well as in its decision to exclude its operating subsidiaries (and their debt) from its Second Case.

In 2018, the company sought bankruptcy protection in the Northern District of Texas in Case No. 18-33967 and requested complex case status based on having more than $10 million in debt and more than 50 parties in interest. It emerged a year later with a confirmed plan that was substantially consummated in March 2020. Under the plan, it pared back its operations from more than 100 facilities to approximately 22 of its best-performing locations.

In 2021, it filed a new case, along with parent company Abri Health Services, LLC, in Case No. 21-30700, and it elected to be treated as a small business debtor filing under subchapter V of chapter 11.

Some Background on Large and Small Cases

The “complex” case designation is not found in the Bankruptcy Code. It references a series of procedures adopted by local rules in various bankruptcy courts to allow the court to more efficiently deal with larger cases.[1] The complexity of the original Senior Care Centers case is shown by the fact that the case has over 3,000 docket entries.

Subchapter V was added to the Bankruptcy Code and went into effect on Feb. 20, 2020. Initially, subchapter V was only applicable to cases with aggregate debt of $2,725,625.[2] However, just one month later, on March 27, 2020, this debt limit was temporarily increased to $7,500,000 by the CARES Act. The debt limit will revert to the original level on March 27, 2022, unless extended by Congress. Subchapter V includes several provisions designed to make smaller cases more affordable. There is no creditors’ committee,[3] disclosure statements are not required,[4] and the absolute priority rule is replaced by a disposable-income requirement.[5]

How Did the Cases Change?

In the First Case, Senior Care Centers and its affiliates entered bankruptcy with $45.56 million in secured asset-based-lending debt.[6] The debtor had $4.33 million in additional secured debt and owed $35 million to landlords. Finally, the debtor owed $36.7 million in unsecured trade debt. Thus, when Senior Care Centers entered the First Case, it had over $120 million in debt and truly qualified as a “complex case.”

When Senior Care Centers filed the Second Case, it reported just $3,065,730 in debt, nearly all of which was unsecured. The schedules stated that $500,000 of unsecured debt consisted of claims classified as “Holders of Allowed Convenience Class Claims” under the plan in the First Case, and that $2,494,717.62 consisted of rent owed to a landlord with which the debtor had ongoing difficulties. The parent company, Abri, listed $2,676,709.02 in debt consisting primarily of the same rental obligations.

Going from $120 million to $3 million in debt is a major feat. Part of this reduction was accomplished by the deleveraging of the company’s balance sheet, which occurred in the First Case. The substantial amounts of secured debt were refinanced and then paid after the First Case, leaving the parent companies relatively debt-free. However, the second reduction in debt came from the decision of which debtors filed bankruptcy. In the First Case, Senior Care Centers filed along with its operating subsidiaries, which had the unsecured trade debt.

In the Second Case, only the two parent companies filed. TXMS Real Estate Investments Inc., the landlord with the large claim in the Second Case, objected to the debtors’ designation as a small business debtor, claiming that they were seeking “to have their cake and eat it, too.” Apparently Senior Care Centers Inc. and the operating entities were all parties to a master lease with TXMS. When Senior Care Centers filed bankruptcy, it contended that the automatic stay prohibited TXMS from terminating the master lease, thus protecting the nondebtor operating entities. However, because the operating entities did not file, Senior Care Centers sought to have their trade debt excluded from the subchapter V eligibility calculation.

The court has not heard the objection, so it is not known whether Senior Care Centers’ strategy to take advantage of subchapter V will succeed. However, its strategy appears to make financial sense. A complex case has complex costs for the debtor. In the First Case, Senior Care Centers was dealing with a panoply of debt. In the Second Case, it was dealing primarily with a single creditor. By limiting the entities that filed, Senior Care Centers could attempt to achieve a more cost-effective remedy for dealing with what it described as a recalcitrant lessor.

---

[1] See, e.g., U.S. Bankruptcy Court for the Northern District of Texas, Local Rules, Appx. E, Procedures for Complex Chapter 11 Cases.

[2] 11 U.S.C. § 101(51D).

[3] 11 U.S.C. § 1181(a).

[4] 11 U.S.C. § 1181(b).

[5] 11 U.S.C. § 1191(b).

[6] Disclosure Statement for Third Amended Plan, p. 5.

NCBJ 2021: Legislative Wish Lists and Realities

This is a combination of two programs. One of the NCBJ plenary sessions offered a Shark Tank like program where three lawyers pitched their proposals to reform the Bankruptcy Code. Meanwhile, at the ABI luncheon, Bill Brandt and Robert Keach offered their prognostications as to what might actually change in the Code. Since both programs involved legislation, I have chosen to combine them here. As you read through this article, you should note that the first part contains the idealism of would-be reformers while the second part contains the realpolitik. 

Shark Tank

Student Loans

In the first program, John Rao of the National Consumer Law Center offered his proposal to amend 11 U.S.C. Sec. 523(a)(8) to rollback dischargeability of student loans to the law as it existed in in 1998 when student loans could be discharged after seven years or on a showing of undue hardship.  He said that the seven-year period deals with the concern that people can come straight out of school and file bankruptcy. He said it's not a complete solution. He said we still need to deal with cost of higher education. 

To make the case for change, he gave the illustration of Karen in Arkansas. She borrowed $10,000 thirty years ago. She never used her degree. Over thirty years, she paid $20,000 but still owed $106,000. Mr. Rao said that there is something fundamentally broken with a system if that is how we treat our debtors. Now the federal student loan creditors can garnish her Social Security and tax refunds and even the Earned Income Tax Credit. There is no statute of limitations on federal student loans so her debts will only disappear when she dies. 

Why did Congress change the law?  (Congress changed the law in 2005 to add some private student loans to the list of non-dischargeable debts and eliminate the ability to discharge student loans after seven years). He pointed out that there was not a single Congressional hearing or GAO report on abuse. He characterized the change in law as a Congressional gimmick to balance the budget. 

Mr. Rao was asked if his proposal would protect the public fisc. There are $1.7 trillion in federal student loans. Why not require payment of disposable income over period?

Mr. Rao responded that most debts are performing. Only about 10% in default. There is no evidence that denying discharge increases revenues to government. Instead, the federal government can capitalize the interest and seek returns that would make a predatory lender blush. The problem with requiring debtors to complete a chapter 13 is that about 50% of Chapter 13 debtors never get a discharge.

Mr. Rao was asked about his proposal to leave undue hardship in in his proposal. He was asked whether it be better to have objective criteria for undue hardship. Mr. Rao said that objective criteria would help but we already have a workable standard for undue hardship in connection with reaffirmation agreements and it would make sense to use that standard. However, he pointed out that the debtors who need relief the most can't afford to litigate. 

He was asked whether his proposal would roil the markets. Wouldn't lenders increase the price to address the risk? He pointed out that the pricing only affects private lenders. When private loans were made non-dischargeable in 2005 there was either no decrease in rates or an actual increase based on different studies.

President Biden has proposed cancelling some student loan debt. Doing this would be a stimulus to economy according to Moody's as more people would be able to buy homes and have children. However, requiring bankruptcy to get that cancellation would avoid the moral hazard of general cancellation. 

KERPs

 

Metta Kurth pitched a proposal to close loopholes to BACPA's limitations on "pay to stay." She called her proposal "stop the heist." In 2005, BAPCPA limited Key Employee Retention Programs ("KERPs") by requiring that a company demonstrate three things: that the person receiving the KERP has received a better offer, that their services are essential and that the amount of the KERP is either not more than 10 times the mean amount paid to non-management employees for similar purposes or, if no similar amounts were paid out in the prior year, it did not exceed 25% of any similar payment made to an insider during the prior year. 11 U.S.C. Sec. 503(c).     

Some companies shifted away from KERPs and went to "keeps," incentive payments to be earned for meeting certain benchmarks. Ms. Kurth said that "keeps" had a greater sense of integrity. However, other companies made an end run around the KERP rules by simply making these payments pre-petition. She gave the example of JC Penney which paid out $7.5 million to four executive five days before the petition. 

Ms. Kurth proposed to amend 11 U.S.C. Sec. 548 in three ways:

(a) Existing Sec. 548(a)(1)(B)(ii)(IV) states that insider compensation given for less than reasonably equivalent value and outside of the ordinary course of business can be recovered as a fraudulent transfer. She would extend this to apply to all insider compensation given during the 90 days before bankruptcy.

(b)  She would also add a provision that insider compensation would be presumed to be for less than reasonably equivalent value if it was greater than the normal pre-bankruptcy compensation and did not meet the requirement for a KERP; and

(c)  Make non-dissenting directors who approve compensation in violation of this provision liable similar to state laws applicable to illegal dividends. 

She was asked if companies would just give out insider bonuses 91 days before bankruptcy if her proposal was adopted. She answered that the petition date is often fluid and that 90 days will catch most abuse. 

She said that her proposal would motivate companies to use a "keep" or stay within guardrails for KERPs during the runup to the petition.

She acknowledged that her proposal would not fix the imbalance in executive compensation. 20 years ago, executives earned 70 times the wage of their typical worker while today that ratio is now 200 times.

She said that she was not trying to fix entire system, just the perception of abuse.

(Ed.: While I admire Ms. Kurth's enthusiasm, her proposal would continue the trend of making the Bankruptcy Code resemble the Tax Code in its complexity. The problem with ever more specific prohibitions is that ever more clever lawyers will find ways around them. To be very clear, she had identified a very real and very serious problem. My quibble is with the specifics of her proposal rather than the need for it)

The Means Test

Eric Brunstad proposing the means test as the gateway for determining substantial abuse. He proposed going back to the standard existing before BAPCPA when Bankruptcy Judges had discretion to find substantial abuse based on the circumstances of the case rather than a statutory presumption. 

He said that the means test was a solution in search of a problem that never existed and a bad solution at that.

He said that judges know abuse when they see it and have ample tools to address it when it actually arises.

He asked the rhetorical question of where did the means test come from? He said it came from the history of credit card underwriting. At one time, credit card underwriting was done on an individual basis. Then it went to a portfolio underwriting system. The model predicted 4% default rate. As time went on, credit cards became less profitable. He said that the credit card companies wanted to squeeze a couple more bucks out of the system by making bankruptcy more difficult and expensive to pursue. (Ed. Prof. Ronald Mann described this as the "sweatbox" in an influential paper). 

He said that the means test was a very inefficient solution. If you are $1 above the test, you are deemed to be a substantial abuse. 

Prof. Brunstad said that the empirical data said abuse was not out there. He also said that a one size fits all test was not useful. He quoted Tolstoy who said, "All happy families are alike; each unhappy family is unhappy in its own way.” He said that by analogy, every abusive debtor is abusive in its own way. 

He stressed that there was not a problem with too many people filing bankruptcy. According to Sen. Elizabeth Warren, 43 million people were in financial distress after the Great Recession, but only 1.5 million filed bankruptcy.  He said that people do not file for bankruptcy willy-nilly

He repeated the proverb that you can't get blood out of stone and then described the means test as a very expensive blood test for the stone.

He said that this kind of discretionary thing (i.e., ferreting out abuse) is what bankruptcy judges are paid to do.

He also said that there is a huge externality problem. He asked who gets the benefit and who bears the cost? The credit card companies reap the benefit from debtors who continue to pay because they cannot afford to file bankruptcy. The cost is borne by higher fees paid by debtors. He said that if a debtor is required to file chapter 13, it is like a 25% tax. 

In the end, the audience voted to invest in all three proposals. Unfortunately, legislative reform depends on a dysfunctional Congress, not what bankruptcy judges and professionals would like to see. That offer a nice segue into the second legislative program I watched.

ABI's Program on Legislative Likelihoods

The three proposals contained in the Shark Tank program were each thought provoking. However, when the American Bankruptcy Institute put on a program on likely changes to legislation, it focused on different proposals altogether. Bill Brandt and Robert Keach are both ABI members who have been active in proposing legislation. Although ABI does not take positions on legislative as a group, its individual members have been active in lobbying Congress. I want to stress that the very opinionated and outspoken Mr. Brandt and Mr. Keach were speaking for themselves rather than for the ABI as an institution. 

SubChapter V

Mr. Brandt started the conversation off with discussion of SubChapter V. He said that when it was passed, the debt limit of $2.7 million was too low. Shortly after it was passed, they were able to increase the limit to $7.5 million but only on a temporary basis. Now he said that the goal would be to increase the limit to $20 million. However, at higher limits, SubChapter V would take on more of a hybrid nature. He said that U.S. Trustee fees would need to kick in at somewhere between $7.5 million to $10.0 million to keep the program funded. He also said that legislation would likely give courts the option to have a creditors' committee beginning at $12-$15 million.

He said that if the debt limit was increase to $20 million, it would cover 95% of Chapter 11 cases. He said that this would take the wind out of the venue issue, which he described as "our abortion issue."

This raises two very interesting questions. Was he assuming that mega SubChapter V cases would not be forum shopped? If the law allows forum shopping and litigants see an advantage to doing so, why would they stop? Also, it wouldn't address the problem of the large public companies seeking out favorable venues to the detriment of smaller creditors, employees, retirees and other constituencies. Also, as a Texan, I am very familiar with the emotions triggered by abortion. On the one hand are those with moral certainty about the importance of lives as yet unborn while on the other there is the moral certainty of those who want to control their own bodies. Abortion stirs the outrage of moral certainty in its combatants. Is bankruptcy venue really that divisive or was Mr. Brandt merely engaging in hyperbole?

 Mr. Keach acknowledged that he had lost the debate over having a facilitating trustee in SubChapter V and that it was good that he lost. He described the trustee as one of the reasons why the Small Business Reorganization Act has worked so well.

Mr. Brandt said that raising the SubV debt limit could make its way into a reconciliation bill because it would raise fees. He also explained that because the support of Sen. Grassley was critical that SubChapter V was intentionally made similar to Chapter 12.

Venue

Mr. Brandt had a very cynical view on venue reform. He said that with this President and Rep. Nadler chairing the House Judiciary Committee, venue would be a non-starter. He said that venue was a good way for Sen. Cornyn and Sen. Warren to raise a lot of money but that it would not be a factor for the balance of this decade.

Mr. Keach said that the option to allow affiliate filings was designed to placate New York bankruptcy lawyers but "no one in New York believes that."

(Ed.: Dissenting Opinion here. For the last three years, Sens. Cornyn and Warren have worked together on a venue bill. This year bills have been introduced into the Senate and House at an earlier stage with more co-sponsors than before. As cases like Purdue Pharma draw national outrage, bankruptcy venue will continue to build momentum. However, I must acknowledge that our scrappy, grass-roots crusade has very determined and well-organized opposition). 

Mr. Brandt said that there was a study that concluded that the bankruptcy industry had the same effect for the Delaware economy as having a minor league baseball team would have. He also said that having increased debt limits for SubChapter V would be a pretty good second choice for the venue reformers. 

Mr. Brandt noted that the fire for venue reform has weakened as the New York-Delaware duopoly has expanded to include Houston and Virginia. (Ed.: Dallas, TX, Corpus Christi, TX and Charlotte, N.C. have also been the recipients of recent attempts at forum shopping. Will forum shopping become so widespread as to draw a collective "meh" from the bar? As the blogger, I get to ask the questions, but I honestly don't have an answer).

He said that 10-15% of the Senate will always oppose venue reform making it an uphill battle. 

He also said that another needed reform would be to allow a single asset real estate debtor to be a SubV debtor if it was a landlord to a small business debtor.

Third Party Releases

Mr. Keach mentioned that when Jon Oliver did a program on third party releases, he had a researcher spend an hour with Mr. Keach. He said that Mr. Oliver gave the issue a very serious presentation. He then said that the issue was not going anywhere. He characterized it as a solution in search of a problem. He said that it was not the bankruptcy system that was broken but the tort system. He said that bankruptcy delivers money to victims faster and more efficiently than the tort system. He said that it is easy to forget that what we are about is compensating people. He said that if you want to punish people, prosecute them. "If you can't prosecute them, then shut up."

Mr. Brandt said that legislation barring third party releases even with an opt out were going nowhere. He said it was a chance for Democrats to say that they voted against Darth Vader. 

Student Loans

Mr. Brandt said that the Fresh Start Bill proposed by Sen. Dick Durbin is the closest bill that might actually achieve passage. It would reinstate dischargeability after ten years and is close to the ABI Commission's proposal. However, he said it was "probably not a this year thing." He added that bankruptcy reform always starts out with consumer provisions. He indicated that it would not be this Congress. Probably the next Congress or the one after that and it would be part of a bill with lots of ornaments on it.

He said that one problem with achieving bankruptcy reform is that there is not an association of past and future debtors but that student loan borrowers vote. Unfortunately, they cannot afford campaign contributions. 

Mr. Keach said that the purveyors of private student loans hired really good lobbyists in the past but that maybe the problem is becoming too significant to ignore.

Final Thought: I really appreciated the fact that Mr. Brandt and Mr. Keach didn't pull any punches. I may not have agreed with them, but they certainly gave their unvarnished opinions without resorting to polite euphemisms. 

Congress to Expand Small Business Eligibility Limits to $7.5 Million

On March 25, 2020, the U.S. Senate passed the Coronavirus Aid, Relief and Economic Security Act” (CARES Act). The House is expected to pass the bill today. One provision of the bill increases the eligibility limits for small business debtors from $2.7 million to $7.5 million. The amendment will only apply to cases commenced after its effective date and will be subject to a sunset provision after one year.

Since many more businesses will be eligible to file under the small business provisions, it is worthwhile to review the pluses and minuses of falling within Subchapter V.  Subchapter V, which is titled Small Business Debtor Reorganization consists of 11 U.S.C. Sec. 1181-1195.