Fourth Circuit ruling clarifies application of exceptions to discharge in Subchapter V | Bradley Arant Boult Cummings LLP

As previously discussed posts and items (here, here and here), in 2019, Congress passed the Small Business Reorganization Act creating the new Subchapter V of Chapter 11 of the Bankruptcy Code. The purpose of Subchapter V was to make small business bankruptcies faster and less costly. However, the substantial benefits of Subchapter V may come at a cost for small businesses.

The recent decision of the Fourth Circuit In re Cleary Packaging, LLC2022 WL 2032296 (4e Cir. June 7, 2022) clarified that in certain cases of sub-chapter V, the statutory exceptions to the bankruptcy discharge will apply to debtor companies. This is a significant change in the law of business reorganization under Chapter 11 of the Bankruptcy Code. Small business lenders may consider pursuing non-discharge claims in bankruptcy cases filed under Subchapter V.

In re Cleary Packaging, LLC

The dispute over the discharge exception that reached the Fourth Circuit began with a state court judgment. Cantwell-Cleary Co., Inc. won a judgment of more than $4 million against Cleary Packaging, LLC, a company formed by the former president and CEO of Cantwell-Cleary. The state lawsuit alleged willful interference with contracts, tortious interference with commercial relationships and related claims. In response to the judgment, Cleary Packaging filed a petition under Chapter 11 of the Bankruptcy Code, electing to proceed under Subchapter V. In its bankruptcy plan, Cleary Packaging proposed to only pay Cantwell- Cleary only 2.98% of his judgment, with the rest of the debt to be discharged. Cantwell-Cleary filed adversarial proceedings seeking to determine that the state court judgment was a debt for “willful and malicious injury” that was not dischargeable under sections 1192 and 523(a)(6) of the Code. bankruptcies. If Cantwell-Cleary prevailed, it meant that Cleary Packaging would not be relieved of the bankruptcy judgment. The bankruptcy court dismissed Cantwell-Cleary’s suit, finding that the exceptions to release under § 523(a) do not apply to corporate debtors. On direct appeal, the Fourth Circuit decided the sole issue of whether Cleary Packaging, as a Subchapter V corporate debtor, can discharge its over $4 million debt to Cantwell-Cleary “for willful and malicious harm”.

The discharge of debts under subchapter V is governed by § 1192(2). This section provides: “If the debtor’s plan is confirmed…the court shall grant the debtor a discharge from all debts…except any debt…of the type specified in Section 523(a) of this title.” In turn, Section 523(a) provides that releases in the specified release provisions of the bankruptcy code, including Section 1192 which applies to Subchapter V, do not release a individual debtor among the 21 types of debt listed in the law. The bankruptcy court interpreted this provision as limiting the exceptions to the discharge only to individual Subchapter V Debtors. On appeal, the Fourth Circuit found that in Subchapter V cases where the debtor fails to confirm a consensual plan, the relief exceptions of § 523(a) apply to individual debtors and corporate.

The Fourth Circuit first turned to the text of § 1192(2), which provides a “debtor” relief. According to the definitions of the Bankruptcy Code, this term includes both individuals and companies, and it is logical that there is no distinction in the discharge that is applied to these debtors. This is also consistent with Subchapter V’s exclusion of the application of the exception to the discharge of a company provided for in § 1141(d) upon liquidation, thus eliminating the distinction between a discharge for an individual and an entity in a liquidation. The court also focused on the wording of section 1192(2), which states that it excludes from release “any debt … of the kind specified in Section 523(a). The Fourth Circuit concluded that the use of the word “debt” was decisive, as it does not lend itself to encompassing the “type” of debtors discussed in § 523(a). Further, the court held that the combination of the terms “debt” and “of the genre” indicated Congress’s intent to refer only to the list of non-dischargeable debts found in § 523(a).

The Fourth Circuit also felt that its interpretation serves fairness and justice. A Subchapter V debtor can confirm a non-consensual plan – that is, a “cram-down” plan – in which business owners can retain their interest without paying the business’s creditors in full. This is a dramatic departure from traditional Chapter 11 cases which are governed by what is known as the “overriding priority rule.” Since an eligible small business debtor receives greater relief in Sub-Chapter V, it should not receive debt relief for fraud, willful and malicious injury, and other violations of public order reflected in the list of exceptions in Section 523(a). at the landfill.

Practical application

Generally, in a traditional Chapter 11, the exceptions to discharge for debtor companies are more limited if the company is not in liquidation. Based on the decision of the Fourth Circuit in In re Cleary Packaging, LLC, Subchapter V includes broader exceptions to the discharge for a debtor who cannot confirm a consensual plan, including claims against corporate debtors for certain types of fraud and other intentional and malicious injuries.

Practitioners and small business lenders should be aware of the applicable exceptions to discharge in Subchapter V and determine whether they should file an adversarial proceeding to declare such debts non-dischargeable. And, if you are seeking such relief, it is essential to keep in mind that the Bankruptcy Code and Bankruptcy Rules provide strict time limits for filing these adversarial proceedings.

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