Can a Lender Have a Nondischargeable Claim Against a Business-Entity Borrower That Files Subchapter V Bankruptcy?

Introduction

Let's review an open issue for lenders: Can a claim against a borrower that is a business entity (e.g., a corporation or limited liability company) be declared nondischargeable in the borrower’s Subchapter V bankruptcy case? The answer is increasingly important, as Subchapter V – which is available to small-business borrowers who have no more than $3,024,725.00 of total debt – is becoming more and more popular.

Subchapter V cases were roughly 45% of all Chapter 11 filings nationally in 2023, and the number of Subchapter V cases filed in Virginia has grown each year since Subchapter V became available in 2020. As of this writing, thirty-five Subchapter V cases have been filed in Virginia in 2024. By comparison, thirty-one such cases were filed in Virginia in all of 2023. The number of Subchapter V filings might decline because the debt limit fell from $7.5 million to $3,024,725.00 as of June 21, 2024 (due to Congressional inaction), but it is reasonable to expect that the $7.5 million limit will be restored.

Under Bankruptcy Code section 523, a creditor can ask a bankruptcy court to declare a debt based on a willful and malicious injury, as well other kinds of debts listed in that section – for example, debts based on a false written financial statement, fraud, false pretenses, false representations, or breach of fiduciary duty – to be nondischargeable in bankruptcy. If the debt is declared nondischargeable, then the creditor will eventually be able to resume collecting from the debtor.

In In re Cleary Packaging, LLC,[1] the Fourth Circuit Court of Appeals, which hears appeals from federal courts in Virginia, ruled that a creditor can pursue a nondischargeability lawsuit against a business-entity borrower in a Subchapter V case. However, a number of other courts around the country have disagreed, and the Supreme Court may need to resolve the issue.

In re Cleary Packaging, LLC

In 2021, Cleary Packaging, LLC (“Cleary Packaging”) filed a Subchapter V case to discharge a creditor’s $4.7 million judgment. The judgment was based on claims of intentional interference with contracts and tortious interference with business relations. The creditor, arguing that those claims amounted to a “willful and malicious injury” inflicted by Cleary Packaging, filed a lawsuit in the bankruptcy case to have the judgment declared nondischargeable.

Cleary Packaging asked the bankruptcy court to dismiss the creditor’s non-dischargeability lawsuit, arguing that section 523 applies only to debts incurred by individuals, not those incurred by limited liability companies, such as Clearly Packaging, or other business entities. Cleary Packaging pointed out that section 523 states that a Subchapter V discharge “does not discharge an individual” from the kinds of debts listed in section 523, thereby implying that it does discharge a business entity from such debts. The bankruptcy court agreed with Cleary Packaging and dismissed the lawsuit.

On appeal, the Fourth Circuit described the issue as a “close one” but held that the bankruptcy court got it wrong and that section 523 does apply to debts incurred by limited liability companies and other business entities. The Fourth Circuit based its ruling on the fact that Subchapter V states that “debt[s] of the kind specified in section 523” can be held nondischargeable but states nothing about the kinds of debtors that can be sued to have a debt declared nondischargeable. Therefore, the reference in section 523 to “an individual” did not control the issue.

Accordingly, in Virginia and the rest of the Fourth Circuit, a creditor can sue a Subchapter V debtor to have a debt declared nondischargeable, regardless of whether the debtor is an individual or a business entity (assuming the creditor does not consent to the debtor’s proposed treatment of the creditor in the bankruptcy case).

The Fourth Circuit’s ruling is a significant win for lenders and other creditors because many small business debtors are business entities, and those entities often own substantially all the assets used in the business. The ruling departs from the general rule in ordinary Chapter 11 cases (i.e., non-Subchapter V cases), which is that a creditor cannot sue a business-entity debtor to have a debt declared nondischargeable. However, a Subchapter V case gives debtors more advantages than an ordinary Chapter 11 case – for example, Subchapter V allows a debtor’s owners to maintain their equity even though creditors will not be paid in full – so the ruling is an appropriate equalizer, which the Fourth Circuit also recognized.[2]

Other Cases Addressing the Issue

Earlier this year, the Fifth Circuit Court of Appeals sided with the Fourth Circuit on this issue. The Fifth Circuit case involved a lender who alleged that its borrower, a limited liability company, had obtained financing from the lender through the use of a false written financial statement. The borrower had stated in writing that it did not anticipate filing Chapter 11, but two weeks later, after obtaining the financing, the borrower filed a Subchapter V case. In ruling for the lender, the Fifth Circuit agreed that Subchapter V’s statement that “debt[s] of the kind specified in section 523” can be held nondischargeable has no bearing upon the kinds of debtors that are subject to being sued for nondischargeability.[3]

In December 2024, the 11^th Circuit Court of Appeals will hear oral argument on the same issue. In that case, the bankruptcy court ruled, contrary to the rulings of the Fourth and Fifth Circuits, that because the debtors in that Subchapter V case were “limited liability corporations, the exceptions to discharge in § 523(a) do not apply.” In other words, the creditor in that case could not pursue a nondischargeability action against the debtor because the debtor was a business entity, rather than an individual.[4]

Further, most of the other courts that have considered the issue have also ruled contrary to the rulings of the Fourth and Fifth Circuits. A recent example is a case out of Georgia, in which the court referred to the Fourth Circuit as a “notable outlier” on this issue.[5] Likewise, the leading authority on Subchapter V bankruptcy also believes the Fourth Circuit’s ruling is incorrect, writing that “the better conclusion is that Congress did not intend that the exceptions to discharge in § 523(a) apply to the discharge of an entity….”.[6]

Takeaway

At present, lenders and other creditors of corporations, limited liability companies, and other business entities who file Subchapter V bankruptcy in Virginia can pursue a nondischargeability lawsuit if they believe the debtor incurred the debt through fraud or other improper means that fall within the bounds of Bankruptcy Code section 523. However, that valuable right seems at risk. Most of the courts around the country that have considered the issue think that lenders and other creditors should not have that right, and another appeals court is scheduled to weigh in on the issue soon. A split among the appeals courts would set the table for the Supreme Court to finally resolve the issue.

Spotts Fain publications are provided as an educational service and are not meant to be and should not be construed as legal advice. Readers with particular needs on specific issues should retain the services of competent counsel.

[1] The case cite is 36 F.4^th 509 (4^th Cir. 2022).

[2] The Fourth Circuit wrote that “Congress understandably applied limitations on the discharge of debts to provide an additional layer of fairness and equity to creditors to balance against the altered order of priority that favors the debtor.”

[3] The case is In re GFS Indus., LLC, 99 F.4^th 223 (5^th Cir. 2024).

[4] The case is In re 2 Monkey Trading, LLC, 650 B.R. 521 (Bankr. M.D.Fla. 2023).

[5] The case is In re RA Custom Design, Inc., 2024 Bankr. Lexis 343 (Bankr. N.D.Ga. 2024).

[6] Hon. Paul W. Bonapfel, Guide to the Small Business Reorganization Act of 2019, revised June 2022, p. 238 (available at https://www.ganb.uscourts.gov/sites/default/files/sbra_guide_pwb.pdf).