Fourth Circuit Weighs in on Scope of a Subchapter V Discharge

06.16.2022

The US Court of Appeals for the Fourth Circuit (which covers Virginia and other Mid-Atlantic states), recently became the first federal appeals court to address which debts a corporate debtor can discharge under chapter 11’s relatively new subchapter V provisions.  

At issue in Cantwell-Cleary Co. v. Cleary Packaging, LLC, 2022 U.S. App. LEXIS 15627 (4th Cir. June 7, 2022) was the relationship between the Bankruptcy Code’s section 1192, which defines the scope of a subchapter V debtor’s discharge, and section 523(a), which excepts from discharge certain types of debt. Section 523(a) by its terms applies only in bankruptcy cases brought by individuals. The Fourth Circuit resolved the interplay between sections 1192 and 523(a) by holding that a subchapter V corporate debtor who confirms a plan over the objection of creditors cannot discharge the types of debts specified in section 523(a). 

As discussed in prior alerts on the Small Business Reorganization Act (SBRA), Congress enacted subchapter V as an alternative to the traditional chapter 11 bankruptcy process. Subchapter V’s objective was a streamlined proceeding under which small businesses could obtain bankruptcy relief a shortened time-frame and at reduced administrative cost. As enacted, the SBRA permitted only companies with non-contingent liquidated debts of less than $2,725,625 to qualify for subchapter V. However, in March of 2020, the CARES Act increased the debt ceiling to $7.5 million for a one-year period. The increased debt limit was renewed for an additional year in March of 2021 but expired on March 27, 2022 due to congressional inaction. The recent Bankruptcy Threshold Adjustment and Technical Corrections Act, which is expected to be signed into law by the President shortly, revives the $7.5 million debt ceiling retroactive to March 27. The $7.5 million debt ceiling will remain in effect for two years and then, in the absence of a further extension, revert to an inflation-adjusted ceiling of $3,024,725. 

Under subchapter V, a plan proposed by the debtor may be confirmed either by consent of all classes of creditors entitled to vote on the plan, or without the consent of these creditor classes. In Cantwell-Cleary Co., the debtor filed for relief under subchapter V. It proposed a plan that would have discharged most of a $4.7 million judgment obtained by a creditor on account of the debtor’s intentional interference with contracts and tortious interference with business relations. If confirmed by the bankruptcy court, the plan would have been on a non-consensual basis.

With respect to subchapter V plans confirmed on a nonconsensual basis, like the plan in Cantwell-Cleary Co., section 1192 provides for the debtor to receive a discharge “except any debt . . . (2) of the kind specified in section 523(a) of this title.” Section 523(a) states, “A discharge . . . does not discharge an individual debtor from [certain enumerated debts, mostly involving intentional torts and other misconduct].” In contrast, section 523(a) does not limit a corporate debtor’s ability to discharge debts in traditional chapter 11 cases that are based upon fraud and other intentional torts.

The question before the Fourth Circuit was whether section 1192 imports section 523(a)’s introductory clause limiting its application to individuals or if section 1192 simply incorporates the types of debts described in section 523(a). The Fourth Circuit took the latter position. It concluded that a corporate subchapter V debtor cannot discharge section 523(a) debts because section 1192 refers to debts “of the kind” set forth in section 523(a) and does not distinguish between corporate and individual debtors. Also central to the court’s reasoning was the debtor-friendly aspects of subchapter V, including a subchapter V debtor’s ability to confirm a nonconsensual plan that provides for the debtor’s owners to retain their interests in the company. In the Fourth Circuit’s view, this potential outcome, which is unavailable to a corporate debtor in a traditional chapter 11 case, justified the departure from the prevailing rule that corporate debtors may discharge section 523(a) debts through a nonconsensual “cram down” chapter 11 plan.

In light of the renewed increase of the subchapter V’s debt limit to $7.5 million, smaller companies looking to restructure due to inflation, rising interest rates, supply chain issues, or lingering Covid challenges may want to evaluate the opportunities offered by subchapter V. These companies should carefully consider Cantwell-Cleary Co.’s impact on the bargaining position of the debtor and creditors during the subchapter V process and negotiation of a subchapter V plan. For prospective subchapter V debtors with debts of the kinds specified in section 523(a), navigating these issues may be critical to the success of a subchapter V filing.

If you are involved in or contemplating a subchapter V case, Hirschler’s experienced bankruptcy team would be happy to assist you.