On February 19, 2020, the Small Business Reorganization Act (the “SBRA”) became effective and created a new subchapter V to chapter 11 of the Bankruptcy Code.  As we have reported, subchapter V presents a new avenue for small business debtors to reorganize more efficiently than traditional chapter 11 cases.  However, the more efficient procedures of Subchapter V are only available to certain types of debtors that meet the eligibility requirements of section 1182(1) of the Bankruptcy Code.  Those eligibility requirements include, among other things, a cap on the aggregate noncontingent secured and unsecured debts a debtor may have (also known as the “debt limit”), requires that the debtor be engaged in commercial or business activities, and excludes certain types of entities subject to the reporting requirements under section 13 or 15(d) of the Securities Exchange Act of 1934 (the “1934 Act”).  Recent amendments to the original language of the SBRA have modified these eligibility requirements and created, and closed, a series of loopholes along the way.

The CARES Act Excludes “Affiliates” of “Issuers” from Subchapter V Eligibility

Just one month after the effective date of the SBRA, President Trump signed into law the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), which offered sweeping legislative responses to the predicted economic toll the coronavirus pandemic would wreak upon the United States economy.  In connection with this focus, the CARES Act provided for a temporary increase in the subchapter V debt limit from $2,725,625 to $7.5 million.  The CARES Act debt limit increase was scheduled to sunset one year later, on March 27, 2021, but was extended to March 27, 2022 by the COVID-19 Bankruptcy Relief Extension Act.  The debt limit was the principal focus of practitioners and potential debtors given its dramatic impact on the number of individuals and entities eligible for subchapter V relief.

But, the CARES Act also effected a more nuanced change to eligibility based on a debtor’s relationship to a nondebtor affiliate that issues equity interests.  The SBRA originally excluded “affiliates” of reporting companies under the 1934 Act.  However, the CARES Act modified section 1182(1)(B) to exclude from subchapter V eligibility companies that were “affiliates” of “issuers” under the 1934 Act.

First, some important definitions.  Under section 101(2)(A) of the Bankruptcy Code, an “affiliate” is an “entity that directly or indirectly owns, controls, or holds with power to vote, 20 percent or more of the outstanding voting securities of the debtor.”  Under section 78c(a)(8) of the 1934 Act, an “issuer” is “any person who issues or proposes to issue any security.”  The 1934 Act provides for a broad definition of “security” that is not limited to securities that trade on public exchanges and encompasses, among other things “stock” or an “investment contract.”

Courts Follow the Plain Language of the CARES Act Modification

Courts took the CARES Act eligibility modification at face value.  In In re Phenomenon Marketing and Entertainment LLC, Case No. 2:22-bk-10132-ER, 2022 WL 1262001 (Bankr. C.D. Cal. April 28, 2022) (Phenomenon I), the United States Bankruptcy Court for the Central District of California considered whether a debtor was eligible to file its subchapter V case where a debtor representative testified that:

• Phe.no LLC (“Phe.no”) is the sole member of the debtor.
• Phenomenon Holdings, LLC (“Holdings”) is the sole member of Phe.no.
• Holdings has a number of members, including the following members who hold more than 20% of the membership interests in Holdings: (i) Phenomenon Blocker LLC (“Blocker”), whose sole member is SBC Berggruen, LLC (“SBC Berggruen”); and (ii) Phe.no Holdings Inc. (“Phe.no Inc.”).
• Sleeping Bear Capital LLC (“Sleeping Bear”) is on the Board of Managers of Holdings.

The court concluded that the debtor was an affiliate of an issuer because Phe.no Inc., a Delaware corporation, ultimately owned 20% or more of the debtor’s voting securities and was a de facto issuer because, as a corporate entity, it must issue stock (there was insufficient evidence on whether it had).  Moreover, Holdings was an issuer because its membership interests satisfied the elements of an “investment contract”—that there was an investment of money in a common enterprise with an expectation of profits produced by the efforts of others.

The debtor claimed that it was not the affiliate of an issuer.  The debtor introduced evidence that, contrary to an earlier declaration, Sleeping Bear was the only entity holding 20% or more of the debtor’s voting securities.  The court rejected the debtor’s argument on the grounds that the debtor had the burden to demonstrate eligibility and its failure to produce confirmatory corporate documents—and the conflicting declaration testimony—should be construed against the debtor.

The court relied on a plain reading of section 1182(1), as modified in the CARES Act.  Rejecting the suggestion that the CARES Act modification was an error in draftsmanship that would lead to absurd results, the court explained that “Congress could have intended that businesses, such as the Debtor here, that are only one component of a more complex corporate structure are not the type of ‘mom-and-pop’ small businesses that should be entitled to take advantage of Subchapter V’s streamlined procedures.” Thus, the court held the debtor was ineligible for subchapter V and converted the case to chapter 11.¹

Congress Revises Subchapter V Eligibility in the Bankruptcy Threshold Adjustment and Technical Corrections Act

On June 21, 2022, President Biden signed the Bankruptcy Threshold Adjustment and Technical Corrections Act (“BTATCA”).  As we reported, the BTATCA further extended the $7.5 million debt limit originally drafted into the CARES Act for an additional two years.  But, with respect to the 1934 Act, the BTATCA returned the eligibility requirements to the original provisions of the SBRA.  Specifically, Congress eliminated the reference to an “issuer” and provided that an entity is not eligible for subchapter V relief if it is subject to the reporting requirements under section 13 or 15(d) of the 1934 Act or if it is an affiliate of such a corporation.  Importantly, likely focused on the $7.5 million debt limit increase that sunset on March 27, 2022, Congress made the provisions of BTATCA retroactive to cases filed on or after March 27, 2022.

Following the enactment of BTATCA, the debtor in In re Phenomenon Marketing & Entertainment LLC filed a motion to modify the court’s ruling in Phenomenon I and reinstate the debtor’s subchapter V designation.

On August 1, 2022, the court agreed and entered an order reinstating the debtor’s subchapter V designation in In re Phenomenon Marketing & Entertainment, LLC, Case No. 2:22-bk-10132-ER, 2022 WL 3042141 (Bankr. C.D. Cal. Aug. 1, 2022) (Phenomenon II).

The court observed there was no dispute “that the Debtor falls within the Act’s definition of debtors eligible to proceed under Subchapter V.”²  The arguments were, instead, limited to whether res judicata applied to the ruling in Phenomenon I and whether BTATCA violated the prohibition on the separation-of-powers principles enunciated in the United States Supreme Court decision, Plaut v. Spendthrift Farm, 514 U.S. 211 (1995).  First, the court found that the debtor’s failure to appeal the Phenomenon I ruling did not bar reconsideration because a basis to appeal—namely Congressional modification of the eligibility requirements—did not exist before the deadline to appeal.  Second, the court held that Plaut did not apply because redesignation would only affect future events in the case; specifically, the debtor would only need to satisfy the more lax confirmation requirements of subchapter V in its forthcoming plan.

A Loophole Re-Emerges for Foreign, Publicly Traded Companies and Their Affiliates

The BTATCA amendments resolve the apparent mistake in the CARES Act modifications that excluded a broad swath of otherwise eligible small business debtors.  However, Congress’s stated desire to limit subchapter V eligibility to small, “mom and pop” companies remains at odds with the plain language of the statute when it comes to foreign, publicly traded companies.

As observed in a recent ABI Journal article,³ section 1182(1)(B) only relates to companies that are reporting companies under the 1934 Act.  However, foreign publicly traded companies and their affiliates may not otherwise qualify as reporting companies under the 1934 Act.  In those cases, section 1182(1)(B) does not serve as a bar to limit such companies’ eligibility for subchapter V relief.  Moreover, section 1182(1) does not include “debts owed to 1 or more affiliates or insiders” within the $7.5 million debt limit.  As the authors of the article observed, this sets the stage for a subchapter V filing by a potentially significant affiliate of a foreign, publicly traded company with intercompany claims that may far exceed the debt limit.

Such a filing remains to be seen, but, in the absence of congressional action, courts adopting a “plain language” construction of section 1182(1)(B) would then be faced with a tough choice: permit such a case to proceed in subchapter V or find that eligibility under such circumstances to be an absurd result contrary to the “mom and pop” intent of subchapter V.  While the latter result may be the intent, it presents an uphill battle for eligibility challenges in such circumstances and a promise of more to come in subchapter V eligibility litigation.

Endnotes

[1] The decision is consistent with at least one other published decision, In re Serendipity Labs, Inc., 620 B.R. 679 (Bankr. N.D. Ga. 2020), converting a subchapter V case to chapter 11 where an affiliate of the debtor issued stock.

[2] Interestingly, neither the court nor parties addressed whether the retroactive provisions of BTATCA were sufficient to save the debtor.  The debtor filed its bankruptcy case on January 10, 2022, but the BTATCA amendments were only made retroactively effective to cases filed on or after March 27, 2022.  To the debtor’s credit, section 1182(1)(B) does not provide when the debtor’s eligibility is tested with respect to the 1934 Act whereas debt limit eligibility, in section 1182(1)(A), is expressly tested “as of the date of the filing of the petition.”

[3] Mark T. Power, et al., “Not so Technical: A Flaw in the CARES Act’s Correction to Small Business Debtor,” Am. Bankr. Inst. J., February 2022.

[View source.]