To prevent "trafficking in corporate shells," the Bankruptcy Code prohibits any discharge of corporate or partnership debts if the debtor is not an "individual" and, in a chapter 11 case, if the debtor proposes a liquidating chapter 11 plan contemplating the cessation of the debtor's business following confirmation.
The U.S. Bankruptcy Court for the District of Delaware recently addressed this prohibition in In re Kabbage Inc., No. 22-10951 (Bankr. D. Del. Mar. 15, 2023). In an unpublished letter ruling, the court concluded that a plan provision permanently enjoining third parties from suing the debtors, their estates, or a court-appointed "wind-down officer" following confirmation could not be confirmed because it was tantamount to a prohibited discharge of the debts of a liquidating corporation. However, instead of simply denying confirmation, the court exercised its broad equitable powers to confirm the plan, as amended to provide for merely temporary injunctive relief until such time that the debtors' assets had been liquidated.
Prohibition of Bankruptcy Discharge for Liquidating Corporations and Partnerships
Section 1141(d)(1) of the Bankruptcy Code provides that, except as otherwise provided in section 1141(d), a chapter 11 plan, or a plan confirmation order, the confirmation of a chapter 11 plan by the bankruptcy court discharges the debtor from any claim or debt that arose before the confirmation date, including claims arising from the rejection of executory contracts or unexpired leases, certain claims arising from the recovery of property by the estate, and certain tax claims. See 11 U.S.C. § 1141(d)(1).
However, pursuant to section 1141(d)(3), the confirmation of a chapter 11 plan does not discharge a debtor if:
- the plan provides for the liquidation of all or substantially all of the property of the estate;
- the debtor does not engage in business after consummation of the plan; and
- the debtor would be denied a discharge under section 727(a) … if the case were a case under chapter 7 of [the Bankruptcy Code].
11 U.S.C. § 1141(d)(3) (emphasis added).
Section 727(a)(1) of the Bankruptcy Code provides that "[t]he court shall grant the debtor a discharge [in a chapter 7 case], unless … the debtor is not an individual." The term "individual" is not defined by the Bankruptcy Code. However, it has been construed to include only "natural persons," as distinguished from corporations, partnerships, and other entities. See, e.g., Friedman v. C.I.R., 216 F.3d 537, 548 n.7 (6th Cir. 2000) (a corporate debtor is not an individual entitled to a chapter 7 discharge); Yamaha Motor Corporation v. Shadco, Inc., 762 F.2d 668, 670 (8th Cir. 1985) ("Congress clearly did not intend the term 'corporate debtor' to be used interchangeably with the term 'individual debtor,' as such a construction would render meaningless employment by Congress of the term 'individual.'" (citations and internal quotation marks omitted)); Consolidated Rail Corp. v. Gallatin State Bank, 173 B.R. 146, 147 (N.D. Ill 1992) ("Although the Bankruptcy Code nowhere explicitly defines the word 'individual' it leaves no doubt that a corporation is not an individual."); In re Automatic Plating of Bridgeport, Inc., 202 B.R. 540, 542 (Bankr. D. Conn. 1996) ("Although 'individual' is not specifically defined under the code, it is apparent from the separate enumeration of individual and corporation in § 101(41) that those entities were intended to be treated separately under the code.").
Section 1141(d)(3) is designed to prevent trafficking in corporate shells and bankrupt partnerships. See H.R. Rep. No. 95-595, 384 (1977); S. Rep. No. 95-989, 130 (1978); Borsdorf v. Fairchild Aircraft Corp. (In re Fairchild Aircraft Corp.), 128 B.R. 976, 982 (Bankr. W.D. Tex. 1991) (stating that "by freighting the [corporate] shell with all the claims, so that any claims or portions of claims not paid by the liquidation will attach to the shell … [the corporate shell becomes] much less attractive for use in starting up another enterprise"); Diego v. Zamost (In re Zamost), 7 B.R. 859 (Bankr. S.D. Cal. 1980) (explaining that, once a corporation's assets are liquidated, it is not necessary to provide it with a discharge); accord In re AB Liquidation Corp., 2006 WL 6810956, *6 (B.A.P. 9th Cir. Dec. 22, 2006). The prohibition of a discharge for liquidating business entities was not the rule under the former Bankruptcy Act of 1898, as amended. See Collier on Bankruptcy ("Collier") ¶ 727(a)(1) (16th ed. 2023) (citing H.R. Rep. No. 95-595, 384 (1977) ("[Section 727(a)(1)] is a change from present law, under which corporations and partnerships may be discharged in liquidation cases, though they rarely are"); S. Rep. No. 95-989, 130 (1978)).
Following liquidation, any dissolution of a corporation or partnership must be effected under applicable state law. See China Nat. Bldg. Material Inv. Co. v. BNK Int'l, LLC, 2015 WL 363275, *8 (W.D. Tex. Jan. 27, 2015); In re Townside Constr., Inc., 582 B.R. 407, 416 (Bankr. W.D. Va. 2018); see generally Collier at ¶ 727.01 ("Under the Code, a corporation or partnership in a chapter 7 case is liquidated only and never receives a discharge. After liquidation, any dissolution of the corporation or partnership that the parties desire must be effectuated under state law, since the Code does not provide for dissolution of corporations or partnerships.").
Taken together, sections 1141(d)(3) and 727(a)(1) prevent non-individual liquidating debtors "from avoiding the operation of section 727(a)(1) through the use of a liquidating plan under chapter 11 instead of a chapter 7 liquidation." Collier at ¶¶ 727.01 and 1141.05.
Because section 1141(d)(3) is written in the conjunctive, "if any one provision does not apply, confirmation of a plan results in the discharge of debt." In re River Capital Corp., 155 B.R. 382, 387 (Bankr. E.D. Va. 1991). Thus, if a corporate debtor's chapter 11 plan does not provide for the liquidation of all or substantially all of the debtor's assets and the debtor continues to operate after its plan is confirmed, the debtor is entitled to a discharge. See In re T-H New Orleans Ltd. P'ship, 188 B.R. 799, 804 (E.D. La. 1995) ("While the debtor would arguably be denied a discharge under § 727(a)(1), the other conjunctive requirements are not met. The court below ably noted that [section 1141(d)(3)(A)] is not satisfied by the facts of this case. The plan does not necessarily provide for liquidation of all property because the debtor has the option of refinancing and paying the creditor in full."), aff'd sub nom. Matter of T-H New Orleans Ltd. P'ship, 116 F.3d 790 (5th Cir. 1997); In re Glob. Water Techs., Inc., 311 B.R. 896, 901 (Bankr. D. Colo. 2004) ("The Court finds that, even though Debtor's Plan contains language that is tantamount to granting of a discharge of pre-petition debts, because the Debtor will resume its business operations post-confirmation, its Plan does not violate § 1141(d)(3)."); accord Broussard v. First Am. Health Care of Ga., Inc. (In re First Am. Health Care of Ga., Inc.), 220 B.R. 720, 725–26 (Bankr. S.D. Ga. 1998); In re Ocean Downs Racing Assoc. Inc., 164 B.R. 245, 247 (Bankr. D. Md. 1993).
Online small business loan and Paycheck Protection Program loan servicing company Kabbage Inc. and its affiliates (collectively, the "debtors") filed for chapter 11 protection in the District of Delaware in December 2022 for the purpose of liquidating their remaining assets after much of the debtors' business was sold in 2020.
The debtors proposed a chapter 11 plan under which the debtors would be liquidated. The plan provided in part as follows: "[A]ll Entities who have held, hold, or may hold Claims against or Interests in the Debtors … are permanently enjoined, on and after the Effective Date [from, among other things,] commencing, conducting, or continuing … any suit … of any kind … against or affecting the Debtors, the Wind Down Estates, or the Wind Down Officer, as applicable."
The Office of the U.S. Trustee (the "UST") objected to confirmation of the plan, arguing that the liquidating debtors were not eligible for a discharge and that the plan language tracked the discharge language in section 524(a) of the Bankruptcy Code.
The Bankruptcy Court's Ruling
The bankruptcy court agreed with the UST.
In an unpublished letter ruling (the "Letter Ruling"), U.S. Bankruptcy Judge Craig T. Goldblatt rejected the debtors' argument that the injunction language in the plan was permissible even though it amounted to a "de facto discharge." Judge Goldblatt stated as follows:
This Court has serious concerns about the propriety of granting relief that is the functional equivalent of a discharge to a debtor that is ineligible for a discharge on the ground that the parties affixed a different label to it. The heart of the equitable authority of bankruptcy courts, Justice Douglas taught in Pepper v. Litton, is "that substance will not give way to form." Otherwise put, bankruptcy law will treat as a duck that which quacks like a duck.
Letter Ruling at pp. 2-3 (footnote omitted). However, instead of denying confirmation of the debtor's plan, the court concluded that "this was a problem to which there was a ready solution that would avoid doing any violence to bankruptcy principles." Id. at p. 3.
Judge Goldblatt explained that the debtors in the case before him did not need the protection of an injunction once they no longer had any assets. Rather, the debtors' sole concern was preventing creditors from acting against the post-effective date entities, including the debtors, their estates, and the court-appointed wind-down officer, while the debtors still had assets. The debtors, Judge Goldblatt emphasized, had no intention of "trafficking in corporate shells," and once they had "distributed their assets in accordance with the plan, and [were] reduced to corporate shells, there is no longer any need to protect them." Id.
According to the bankruptcy court, "the readily available solution, therefore, is to afford those entities not permanent injunctive relief, but rather temporary injunctive relief that will remain in effect only as long as those entities hold assets." Id. (emphasis added). Because the injunctive relief would expire upon the distribution of the debtors' assets, Judge Goldblatt concluded, such relief was "not the functional equivalent of a discharge, and the granting of such relief would not run afoul of § 1141(d)(3) or the purposes it serves." Id. This solution, the judge reasoned, operated to "carry out" the provisions of the Bankruptcy Code and was therefore a legitimate exercise of the court's equitable authority under section 105(a) of the Bankruptcy Code, which provides that "[t]he court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of [the Bankruptcy Code]."
Finally, the bankruptcy court noted that its ruling comported with the U.S. Supreme Court's rulings limiting the exercise of a bankruptcy court's equitable powers under section 105(a), including: (i) Law v. Siegel, 571 U.S. 415, 421 (2014), where the court cautioned that section 105(a) may not be used to "contravene specific statutory provisions"; and (ii) Czyzewski v. Jevic Holding Corp., 580 U.S. 451, 464-69 (2017), in which the Court elaborated that a bankruptcy court's equitable discretion is limited not only by the express language of the Bankruptcy Code but also by any reasonable inferences that can be made based upon that language regarding lawmakers' intent.
The bankruptcy court accordingly confirmed the debtors' chapter 11 plan, as revised.
There are two key takeaways from the bankruptcy court's letter ruling in Kabbage.
First, strong policy considerations underpin the prohibition in the Bankruptcy Code of a discharge for liquidating corporations and partnerships. As a consequence, courts view with skepticism attempts to skirt that prohibition by characterizing a de facto liquidating corporate or partnership discharge as something else. See, e.g., In re New Towne Dev., LLC, 410 B.R. 225, 232 (Bankr. M.D. La. 2009) (under Fifth Circuit precedent, a liquidating chapter 11 plan for a corporate debtor improperly included third-party releases and permanent injunctions—effectively a discharge—where the liquidating debtor itself could not receive a discharge under sections 1141(d)(3) and 727(a)(1)).
Second, Kabbage illustrates the broad scope of a bankruptcy court's equitable authority within the constraints established by the U.S. Supreme Court.
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