If a business engages in bad behavior like intentional interference with contract and tortious interference with business relations, then it may not use Subchapter V of Chapter 11 to discharge debts based on that bad behavior.
That is the upshot of a recent ruling by the United States Court of Appeals for the Fourth Circuit, which sets the rules for federal bankruptcy courts in North Carolina. In In re: Cleary Packaging, the Fourth Circuit held that Section 523(a) of the Bankruptcy Code prohibits discharge of 21 categories of debt, including debts for willful and malicious injury by the debtor to another entity or that entity's property.
Cantwell-Cleary is a wholesale office-supply company. Vincent Cleary Jr. was a director and its former president and CEO. And he was not happy. He left to form his own company – Cleary Packaging. On his way out the door, he took sensitive customer information and several employees covered by non-compete agreements, and set about to take Cantwell-Cleary's business. Cantwell-Cleary sued him and Cleary Packaging in state court for intentional interference with contract, tortious interference with business relations, and related claims and obtained a $4.7 million judgment.
Cleary Packaging then filed for bankruptcy under Subchapter V. Under Subchapter V, a debtor can confirm a plan over creditor objections if it contributes all "projected disposable income" to plan payments over three to five years. Cleary Packaging's plan proposed to pay Cantwell-Cleary about $140,000, or just under three percent of its judgment over five years, and discharge the balance.
Cantwell-Cleary argued it held a kind of debt – one for willful and malicious injury – that cannot be discharged under Subchapter V. Under the Bankruptcy Code, an individual debtor can't discharge that kind of debt. The issue was whether a corporate debtor could discharge the debt. The bankruptcy court said it could, but the Fourth Circuit reversed.
Why? The "absolute priority" rule. In a traditional Chapter 11 reorganization, the debtor submits and the court approves a plan of reorganization. If creditors object, the court must conclude the plan is fair and equitable and complies with priority rules that establish a hierarchy of creditor classes for the order in which each class will be paid. Higher priority creditors are paid in full before payment to lower priority creditors. Equity owners can't retain estate property for themselves unless they pay all creditors in full. So while just about any debt can be discharged in Chapter 11, a bankruptcy court cannot confirm a non-consensual plan that violates the absolute priority rule.
Subchapter V eliminates the absolute priority rule. It creates a more streamlined and less expensive Chapter 11 reorganization path for small business debtors. To confirm a plan, the bankruptcy court need only find it is feasible and all the debtor's projected disposable income will be paid to creditors for three to five years. The owners of a Subchapter V debtor can retain their equity in the bankruptcy estate over creditors' objections. And Subchapter V requires a court to grant a discharge of all debts after plan approval except (1) any debt payable after the repayment period and (2) any debt of the kind specified in section 523(a). Section 523(a) is the "bad behavior" list.
Against this backdrop, the Fourth Circuit concluded that fairness and equity required the bad behavior list apply to all Subchapter V debtors – individual or corporate. A contested Subchapter V leads to a "cram-down" proceeding in which creditors are treated differently than they would be in traditional Chapter 11 under the absolute priority rule. Under a Subchapter V plan, the debtor's owners can retain ownership interests at the expense of and over the objection of creditors. Given the elimination of the absolute priority rule, Subchapter V limits what debts can be discharged "to provide an additional layer of fairness and equity to creditors to balance against the altered order of priority that favors the debtor." Small business debtors with debts arising from fraud, willful and malicious injury, or other violations of public policy simply can't use Subchapter V to slough them off for pennies on the dollar.
Creditors who find themselves in Subchapter V may not always have a debt of the kind found on the bad behavior list. But if they do, they will have powerful leverage against the debtor. They can require the debtor to pay the claim in full as a condition to confirmation of the debtor's Subchapter V reorganization plan. Or they can force the debtor to file a traditional Chapter 11, where the debtor's owners won't be able to retain any equity interest until the claim is paid in full.