Bankruptcy Judge Edward L. Morris of Fort Worth, Texas is the latest judge to address whether the owner of a defunct business qualifies for reorganization as a small business debtor under subchapter V of chapter 11, holding that debtors not engaged in a commercial or business activity are ineligible. Judge Morris sided with Bankruptcy Judge Cynthia A. Norton of Kansas City, Mo., who similarly ruled that debtors must be currently engaged in business to qualify for reorganization under subchapter V of chapter 11. In re Thurmon, 20-41400, 2020 WL 7249555 (W.D. Mo. Dec. 8, 2020). Judge Morris also cited but disagreed with In re Wright, 20-01035, 2020 WL 2193240 (Bankr. D.S.C. April 27, 2020), where Bankruptcy Judge Helen B. Burris of Spartanburg, S.C., held that restructuring the debt of a defunct business is enough to qualify under subchapter V.
In Johnson, the debtors, a married couple, filed joint voluntary petitions for relief under chapter 7 of the Bankruptcy Code. In re Johnson, 19-42063 (Bankr. N.D. Tex. March 1, 2021). The United States Trustee for Region 6 (the “UST”) initiated an adversary proceeding against the debtors to object to their chapter 7 discharge and in response, the debtors filed a motion to convert their chapter 7 cases to a case under subchapter V of chapter 11 (the “Motion”). The Motion was filed to avoid the UST’s discharge objection. The UST and several creditors objected to the Motion arguing that the debtors were ineligible for relief under subchapter V of chapter 11.
Prior to filing their chapter 7 case, the debtors, and specifically one of the debtor spouses, owned and managed seven oil and gas companies that became defunct (the “Defunct Companies”). Many creditors of the Defunct Companies pursued litigation against the debtors based on alleged fraudulent acts. As of the petition date, neither of the debtors owned an interest in any operating businesses and neither of the debtors were engaged in any business enterprises with respect to the Defunct Companies. One of the debtor-spouses was employed by his mother’s oil and gas company as the president, however, he had no ownership interest in his mother’s company.
The Court examined the statutory basis for conversion of the chapter 7 case to chapter 11 ultimately holding that the debtors were not eligible to convert their case to one under subchapter V. Pursuant to section 706 of the Bankruptcy Code, a chapter 7 debtor may convert its chapter 7 case to a case under chapter 11 at any time if the debtor may be a debtor under chapter 11 and the bankruptcy case was not previously converted under section 1112, 1208 or 1307 of the Bankruptcy Code. Under Section 109 of the Bankruptcy Code, with the exception of a stockbroker and commodity broker, a person that may be a debtor under chapter 7 of the Bankruptcy Code may also be a debtor under chapter 11 of the Bankruptcy Code.
In the Johnson, the debtors were statutorily eligible for chapter 7 relief – their case was not previously converted from one under a different chapter and neither of the debtors were stockbrokers or commodity brokers. With these points in mind, the Court examined the debtors’ eligibility under subchapter V of chapter 11 as the debtors bore the burden of establishing their eligibility.
Subchapter V was added to the Bankruptcy Code by the Small Business Reorganization Act of 2019, effective February 19, 2020 (the “SBRA”). With the addition of subchapter V, section 103(i) of the Bankruptcy Code now provides that subchapter V of chapter 11 “applies only in a case under chapter 11 in which a debtor (as defined in section 1182) elects that subchapter V of chapter 11 shall apply. Section 1182 provides that a “debtor” means a “small business debtor” and section 101(51D) of the Bankruptcy Code defines a “small business debtor” as “a person engaged in commercial or business activities…that has aggregate noncontingent liquidated secured and unsecured debts as of the date of filing the petition…” Statutorily, to qualify as a “small business debtor” eligible for relief under subchapter V of chapter 11 one must, among other things be engaged in commercial or business activities or be an affiliate of such a debtor.
Judge Morris specific addressed the meaning and temporal scope of subchapter V — the parties disagreed as to the meaning of “engaged in commercial or business activities,” and neither of these terms are defined in the Bankruptcy Code. The debtors argued that the term “engaged in” had no temporal limitation and could therefore refer to current and former commercial or busines activities. Under this interpretation, the debtors’ prior ownership and management of the Defunct Companies would qualify the debtors as a person “engaged in” commercial or business activities under section 101(51D). The UST and creditors disagreed, arguing instead that a debtor must be actively carrying out commercial or business activities at the time of the filing of the petition to be “engaged in commercial or business activities” to meet the standard set forth in section 101(51D). Under this interpretation, because the debtors were no longer actively carrying out any activity with respect to the Defunct Companies as of the petition date, they failed to qualify as a person engaging in commercial or business activities under 101(51D).
The Court ultimately sided with the UST and creditors’ holding that the “engaged in” inquiry requires an assessment of the debtor’s current state of affairs as of the petition date. Judge Morris examined the purpose of language in section 101(51D) and its legislative history noting that this section was designed to identify debtors in particular need of the benefits of small business treatment—benefits that are largely designed to facilitate expediency and minimize costs within the bankruptcy process. These processes wouldn’t be essential for small business that are actually no longer in business.
Under the facts of this case, it was clear to Judge Morris that each of the Defunct Companies had ceased all commercial and business activities prior to the petition date, and the debtors were not occupied with or actually dealing with any business dealings related to the Defunct Companies. Judge Morris also analyzed whether the debtor-spouse was engaged in “commercial or business activities.” The debtor contended that managing his mother’s company enabled the debtors to qualify under subchapter V but to this point Judge Morris noted that the debtor was “nothing more than an employee” and was not conducting his mother’s business for his own profit. Looking to 101(51D), the Judge held that “a person engaged in ‘commercial or business activities’ is a person engaged in the exchange or buying and selling of economic goods or services for profit.” Being an employee of his mother’s company, even with “heightened obligations . . . . [did] not qualify as a small business debtor under section 101(51D).”
For all these reasons Judge Morris denied the debtors motion for conversion to chapter 11 because it was conditioned on qualifying for subchapter V. This split of authority for subchapter V eligibility across courts in the United States will be important as creditors and other parties examine debtor’s requests to file and/or convert their cases.