On occasion, a bankruptcy judge will write an opinion implicitly telling both sides how to settle. That’s the case with a recent opinion by Bankruptcy Judge Deborah L. Thorne of Chicago. Whether the warriors take the hint is yet to be seen.

Judge Thorne’s opinion dealt with the quantum of proof required for satisfaction of the “fair and equitable” confirmation standard applicable to nonconsensual chapter 11 plans in Subchapter V. The November 8 opinion effectively tells the creditor what the recovery could be on an allegedly nondischargeable debt, were the creditor and the debtor to settle.

The opinion shows when a “true-up” in the plan might enable the debtor to confirm and break a deadlock with the creditor.

The Statute on ‘Fair and Equitable’

Judge Thorne said that the debtor had been litigating with its principal creditor “for years.” The creditor had won an arbitration award against the corporate debtor and its owner for about $2.4 million based on claims for tortious interference with the creditor’s business. An objection to confirmation of the award was before the state court when the corporate debtor filed a petition under Subchapter V of chapter 11.

The debtor’s plan called for paying all creditors in full other than the creditor. The creditor objected to confirmation and had filed a complaint contending that the claim was nondischargeable.

With a nonconsensual plan, the debtor was obliged to satisfy the “fair and equitable” test in Section 1191(b). The subjection directs the court to “confirm the plan . . . if the plan does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.”

For a plan to be “fair and equitable,” Section 1191(c) requires the debtor to devote all “projected disposable income” to plan payments for three to five years. Section 1191(d) defines “disposable income” to mean “the income that is received by the debtor and that is not reasonably necessary to be expended [for] the payment of expenditures necessary for the continuation, preservation, or operation of the business of the debtor.”

How Courts Interpret ‘Fair and Equitable’

Judge Thorne said that “few courts” have opined on the meaning of “fair and equitable” in Subchapter V “because Sub. V is still quite new compared to the rest of the Code.” Citing Section 1190(1)(C), she said that the debtor bears the burden of proof and “must provide projections demonstrating the debtor’s ability to make payments under the proposed plan and explain how the debtor is calculating its projected disposable income.” The “debtor must satisfy the court that the projections are credible,” although projections are not an “exact science.”

When there is an objection to “the reasonableness of expenses,” Judge Thorne said that “the debtor at minimum must be able to explain to the court’s satisfaction how those costs have been calculated.” Noting that chapter 12 has “the exact same wording,” she cited the Seventh Circuit for saying in a chapter 12 case that the “disposable income provision exists ‘to prevent large expenditures by debtors for non-essential items which ultimately reduce the sum available to pay holders of unsecured claims.’” In re Fortney, 36 F.3d 701, 704 (7th Cir. 1994).

To establish that the plan is “fair and equitable,” Judge Thorne said that the debtor “must show that there is a reasoned basis for its projections, and . . . that line items deducted from disposable income are indeed ‘necessary for the continuation, preservation, and operation of the debtor’s business.’”

Insufficient Evidence Regarding Expenses

There was evidently no dispute about projected income, but the creditor objected to the expenses for depreciation, taxes and legal fees. Judge Thorne dealt with the items one by one.

At the confirmation hearing, only the Subchapter V trustee testified. The debtor’s owner was in the courtroom but did not take the stand.

The failure to call the owner to the witness stand likely resulted in Judge Thorne’s decision to reject confirmation, because the trustee lacked knowledge beyond the worksheets he had been given by the debtor. With regard to projected taxes, she said that the trustee “could not explain to the court where the numbers on the spreadsheet came from, how they related to the business’s income, or on what basis the debtor had historically made tax reimbursements to principals.”

Regarding depreciation expense, Judge Thorne said there was “no way for the court to know if the reserve is necessary to the continuation, preservation, and operation of the business” without “knowing what, if any, equipment will need to be replaced, or what other capital expenditures might be funded with the reserve.” She went on to say that the debtor’s owner, “who was on [the debtor’s] witness list . . . might have provided this information.”

Judge Thorne said she “had no basis to conclude that the plan was fair and equitable, and it cannot be confirmed,” because the debtor “did not meet its burden of showing that its projections for taxes and depreciation were credible.”

The Economics of a Confirmable Plan

In the year before filing, the debtor had spent about $450,000 litigating with the creditor. For the five years in chapter 11, the debtor was projecting another $740,000 in legal expenses, presumably in litigating with the creditor over dischargeability and plan confirmation. In addition, the debtor was predicting $200,000 in depreciation expense and $475,000 in taxes. The projected expenses, totaling some $1.4 million, were more than the projected net income of about $1.2 million.

Were the plan confirmed and were the debtor to defeat the creditor in ongoing litigation before the end of the plan, the unspent expenses would drop into the owner’s pocket, because no one other than the debtor in Subchapter V may modify a plan. To prevent a windfall, the solution was a so-called “true-up.”

“While courts disagree about whether a bankruptcy judge can require a true-up,” Judge Thorne said, “there is no binding precedent to prevent a court from confirming a plan where a debtor has included such a provision,” which “may be especially appropriate where, as here, a debtor sets aside large reserves for projected capital expenditures that benefit its insiders at the expense of its creditors.” [Emphasis in original.]

Judge Thorne saw the case as “a two-party dispute,” and concluded that the plan is not fair and equitable where the debtor’s “primary focus is to evade paying a creditor rather than commit the debtor’s total projected disposable income.”

Judge Thorne denied confirmation of the plan, without prejudice to filing an amended plan.

Observations

Kudos to Judge Thorne for writing an opinion with enough detail to explain how the case could end with confirmation benefiting both sides.

Conceivably, the debtor could fix the problems that Judge Thorne identified to confirm a plan over the creditor’s continuing objection. However, victory would be short-lived were the creditor to prevail on nondischargeability.

In that regard, the odds are stacked against the debtor, because Judge Thorne ruled in July in the very same case that debts of corporate debtors can be nondischargeable in Subchapter V. See Christopher Glass & Aluminum Inc. v. Premier Glass Services LLC (In re Premier Glass Services LLC), 661 B.R. 939 (Bankr. N.D. Ill. July 31, 2014). To read ABI’s report, click here.

Prudence would have the debtor settle rather than roll the dice.

If the creditor aims to collect as much as possible on the arbitration award, settlement makes sense. Defeating an amended plan or winning on nondischargeability could result in little recovery in a liquidation.

The opinion gives the creditor a rough idea of how much it could collect in settlement through a plan. Although a plan with lower expenses may not pay the creditor in full, a plan would be better than a kick with a snowshoe, as my old pappy would say.