If a company engages in bad behavior, such as intentional interference with contract and tortious interference with commercial relations, it cannot use Chapter 11 Subchapter V to discharge its debts because of this bad behaviour.
This is the result of a recent decision 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 PackagingThe Fourth Circuit ruled that Section 523(a) of the Bankruptcy Code prohibits forgiveness of 21 categories of debts, including debts for willful and malicious injury by the debtor to another entity or that entity’s property.
Cantwell-Cleary is an office supply wholesale company. Vincent Cleary Jr. was a director and its former president and CEO. And he was not happy. He left to start his own company – Cleary Packaging. On his way out, he took sensitive customer information and several employees covered by non-compete agreements, and proceeded to take Cantwell-Cleary’s business. Cantwell-Cleary sued him and Cleary Packaging in state court for willful interference with contract, tortious interference with commercial relations, and related claims and won a judgment for $4.7 million.
Cleary Packaging then filed for bankruptcy under Subchapter V. Under Subchapter V, a debtor can confirm a plan over creditors’ objections if they contribute all “projected disposable income” to plan payments on three to five years. Cleary Packaging’s plan proposed to pay Cantwell-Cleary about $140,000, just under three percent of its judgment over five years, and discharge the balance.
Cantwell-Cleary argued that she held some kind of debt – one for willful and malicious injury – which cannot be discharged under Subchapter V. Under the Bankruptcy Code, an individual debtor cannot discharge this type of debt. The question was whether a debtor company could discharge its debt. The bankruptcy court said it was possible, but the Fourth Circuit backtracked.
Why? The “absolute priority” rule. In a traditional Chapter 11 reorganization, the debtor submits and the court approves a reorganization plan. If the creditors object, the court must conclude that the plan is fair and equitable and complies with the priority rules which establish a hierarchy of classes of creditors for the order in which each class will be paid. Priority creditors are paid in full before payment to lower priority creditors. Stock owners cannot keep estate assets for themselves unless they pay all creditors in full. So while almost any debt can be discharged in Chapter 11, a bankruptcy court cannot uphold a non-consensual plan that violates the top priority rule.
Subchapter V removes the absolute priority rule. It creates a more streamlined and less costly Chapter 11 reorganization path for small business debtors. To confirm a plan, the bankruptcy court need only find that it is feasible and that all of the debtor’s projected disposable income will be paid to creditors for three to five years. Owners of a Subchapter V debtor may retain their equity in the bankruptcy estate despite objections from creditors. And Subchapter V requires a court to grant a discharge of all debts after plan approval, except (1) any debt due after the repayment period and (2) any debt of the type specified in section 523(a). Section 523(a) is the list of “bad behavior”.
In this context, the Fourth Circuit concluded that justice and fairness required that the list of misconduct apply to all Subchapter V debtors – individuals or corporations. 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, owners of the debtor may retain property rights at the expense and despite the objection of creditors. In view of the elimination of the absolute priority rule, subchapter V limits the debts that can be discharged “in order to provide an additional layer of fairness and equity to creditors to offset the modified order of priority which favors the debtor”. Small business debtors with debts resulting from fraud, willful and malicious injury, or other breaches of public order simply cannot use Subchapter V to strip them for pennies on the dollar.
Creditors who end up in subchapter V may not always have debt of the type listed 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 of confirming the debtor’s 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 interest until the debt is paid in full.
© 2022 Ward and Smith, Pennsylvania. All rights reserved.National Law Review, Volume XII, Number 182