Having a “profit motive” is not a requisite for eligibility to reorganize under Subchapter V of chapter 11, according to the Ninth Circuit Bankruptcy Appellate Panel. Likewise, eligibility does not depend on conducting historical operations on the filing date.
The April 26 opinion for the BAP by Bankruptcy Judge Julia W. Brand also held that the debtor bears the burden of proof in establishing eligibility for Subchapter V.
The Non-Profitable Business
The debtor leased fractional interests in private jet aircraft from a company in the business of leasing fractional interests. The relationship had been successful for more than 15 years when disputes arose.
As a consequence of the disputes, the lessor did not allow the debtor to use any jets beginning sometime in 2017. Eventually, the lessor filed suit in a state court for breach of contract. The debtor counterclaimed for breach of contract and fraud.
On the eve of trial, the debtor filed a chapter 11 petition and elected treatment as a small business debtor under Subchapter V. The lessor held 98% of the debtor’s non-insider debt.
The lessor objected to the debtor’s eligibility to proceed under Subchapter V because it was not engaged in business, had not been since 2017, and never had any intention of generating a profit. The debtor countered by saying that the business was designed to throw off tax deductions for the owner.
The bankruptcy judge overruled the objection and later confirmed the debtor’s plan, after overruling the same eligibility objection a second time.
The lessor appealed to the BAP from both the confirmation order and the order overruling the eligibility objection.
Profit Motive
The outcome of the appeal was governed by the BAP’s interpretation of the eligibility rules contained in Section 1182(1)(A). As long as the debtor does not own single asset real estate, has not more debt than the statute allows, and is not a reporting company, the section says that a debtor may be
a person engaged in commercial or business activities . . . that has aggregate noncontingent liquidated secured and unsecured debts as of the date of the filing of the petition . . . [of] not more than [$7,500,000] . . . not less than 50 percent of which arose from the commercial or business activities of the debtor.
Judge Brand said that the “only question here is whether [the debtor] was ‘engaged in commercial or business activities’ within the meaning of § 1182(1)(A).”
Although “the case law is sparse,” Judge Brand said that a “majority of courts have held that a debtor need not be ‘actively operating’ on the petition date, but must be ‘presently’ engaged in commercial or business activities on the petition date to satisfy § 1182(1)(A).”
Although the term “engage in” is not “retrospective,” Judge Brand said that “a debtor need not be maintaining its core or historical operations on the petition date, but it must be ‘presently’ engaged in some type of commercial or business activities to satisfy § 1182(1)(A).”
When the debtor “is no longer operational,” Judge Brand turned to the question of what activities satisfy the statutory requirement. She said that courts generally hold “that the scope of commercial or business activities is very broad.”
The lessor argued that the debtor never turned a profit and never intended to turn a profit. The debtor responded by saying that the debtor’s business plan was designed to generate tax depreciation on the aircraft that would flow through to the debtor’s owner.
Judge Brand said that the “few courts that have addressed [the issue] have held that § 1182(1)(A) does not require a debtor to be engaged in for-profit business to qualify for subchapter V.” Among the authorities, she cited the case of a nonprofit homeowners’ association that was held eligible for Subchapter V on appeal in district court.
Judge Brand noted that Congress did not exclude nonprofit entities from Subchapter V. It “makes sense,” she said, because nonprofit organizations are permitted to file in chapters 11 and 7. She also noted that Congress had only excluded single-asset real estate owners and reporting companies and their affiliates.
Judge Brand held that “no profit motive is required for a debtor to qualify for subchapter V relief.” She added, “To hold otherwise would wrongfully exclude nonprofits and other persons that lack such a motive. That [the debtor] had no profit motive did not render it ineligible for subchapter V.”
What Are Sufficient Business Activities?
Having concluded that the debtor was not categorically barred from Subchapter V, Judge Brand turned to whether the debtor had the requisite “commercial or business activities” on the filing date.
The bankruptcy court had found that the debtor was sufficiently engaged in business by litigating with the lessor, paying aircraft registry fees, remaining in good standing as a Delaware corporation, filing tax returns and paying taxes.
Judge Brand held that “the activities identified by the bankruptcy court are ‘commercial or business activities’ within the meaning of § 1182(1)(A)” and that the debtor “was ‘engaged in’ these activities on the petition date.”
Burden of Proof
The bankruptcy court believed that the lessor had the burden of proof to show that the debtor was ineligible for Subchapter V. Judge Brand disagreed, but the error was harmless.
The Bankruptcy Code and Rules are silent on the burden of proof regarding Subchapter V eligibility, and neither the circuit nor the BAP had answered the question. On the other hand, debtors have the burden of proof regarding eligibility in chapters 12 and 9.
“Nearly every court” that has confronted the issue has put the burden on the debtor in Subchapter V, Judge Brand said, “especially considering the many advantages subchapter V offers debtors over a ‘traditional’ chapter 11.”
The error was harmless because the debtor had nonetheless elicited sufficient facts to shoulder the burden. The BAP therefore affirmed both the confirmation order and the order upholding the debtor’s eligibility for Subchapter V.
Having a “profit motive” is not a requisite for eligibility to reorganize under Subchapter V of chapter 11, according to the Ninth Circuit Bankruptcy Appellate Panel. Likewise, eligibility does not depend on conducting historical operations on the filing date.
The April 26 opinion for the BAP by Bankruptcy Judge Julia W. Brand also held that the debtor bears the burden of proof in establishing eligibility for Subchapter V.