Insight Exceptions to Discharge Apply only to Individuals Even in a “Cramdown” Subchapter V, Chapter 11 Case

In a recent opinion, the Bankruptcy Court for the District of Idaho addressed an issue our clients frequently inquire about: whether a business’s debts can be excepted from discharge under 11 U.S.C. § 523(a) in the business’s bankruptcy. The Court applied the applicable statutes and determined the debts cannot be excepted from discharge in the entity’s bankruptcy case, even one under the relatively new Subchapter V, Chapter 11 statutes, in Catt v. Rtech Fabrications, LLC (In re Rtech Fabrications, LLC), Adv. No. 21- 07002-NGH, 2021 WL 4204800 (Bankr. D. Idaho Sept. 15, 2021).

Facts and Procedural History

The facts of the case that brought this issue before the Court are straightforward. Catt contracted with Rtech Fabrications, LLC (the “Debtor”) in 2016, through 2020, for the Debtor to build and modify two custom vehicles for Catt. The relationship soured and Catt filed a lawsuit in state court against the Debtor, alleging breach of contract, fraud, and alter ego claims—against the Debtor’s principals. The state court subsequently issued an order attaching certain property owned by the Debtor. The Debtor filed its Subchapter V, Chapter 11 case the next day.

Catt followed the Debtor to bankruptcy court and filed an exception to discharge adversary proceeding pursuant to 11 U.S.C. § 523(a) against the Debtor (the company) and other claims against the principals (the individuals) of the Debtor. The Debtor then moved to dismiss the claims against it under 11 U.S.C. § 523(a), arguing that it, as a company, was not subject to the exceptions to discharge under 11 U.S.C. § 523(a), which expressly refers to debts that are not dischargeable in an “individual’s” bankruptcy case.

The Bankruptcy Court agreed, but in doing so it addressed an interesting omission from the relatively new provisions of Subchapter V, Chapter 11. The principals also moved to dismiss based on lack of subject matter jurisdiction of the Bankruptcy Court as to them, however, this analysis is not discussed in this blog.

Applicable Bankruptcy Law

The Bankruptcy Code (11 U.S.C. §§ 101 – 1532) is a well-organized, complex statutory scheme for individuals and businesses to address their debt burdens. The Code also balances a debtor’s ability to reorganize or liquidate with the interest and rights of the debtor’s creditors and other interest holders. The Code’s first three chapters (Chapters 1, 3, and 5) all apply to the substantive bankruptcy chapters of the Code (Chapters 7, 9, 11, 12, 13, and 15), except as modified in those substantive chapters. At issue in the above case is a particular statute found in Chapter 5, as applicable to Chapter 11, of 11 U.S.C. § 523(a).

Section 523(a) provides: “A discharge under section . . . 1141 . . . 1192 . . . of this title does not discharge an individual debtor from any debt— . . . .” 11 U.S.C. § 523(a) (emphasis added). The statute goes on to list 19 “exceptions to discharge”, which detail debts that are not dischargeable in an individual’s bankruptcy case. Id. Some of the provisions are self-effectuating—meaning to the extent that the statute applies, the debt is simply not dischargeable in bankruptcy. Other provisions require an affirmative act of the creditor in the bankruptcy case to request a determination by the bankruptcy court that the debts are not dischargeable. See 11 U.S.C. § 523(c)(1) (stating the debtor will receive a discharge of a debt qualifying under § 523(a)(2), (a)(4), or (a)(6) unless the creditor requests that the bankruptcy court determine such a debt should be excepted from discharge).

Chapter 11 is a reorganization chapter of the Bankruptcy Code for individuals, small businesses, and massive corporations alike. In a Chapter 11 case, generally, the debtor proposes a plan to repay its creditors, which plan is voted upon by creditors and other interest holders of the debtor. If the plan is confirmed, with approval of creditors or not, its provisions control and the debtor proceeds to fulfill its commitments under the plan, hopefully, in a manner that allows the debtor to continue operating.

Chapter 11 is a complicated statutory scheme that is sometimes a difficult and perilous path for debtors to walk. In 2019, Congress meant to fix the presumed onerous provisions of Chapter 11 to help a favored class of debtors—the “small business debtor”. Subchapter V of Chapter 11 was created as a part of the Small Business Reorganization Act of 2019 (“SBRA”) to that end. Pub. L. No. 116-54, 133 Stat. 1079 (2019). Generally, the SBRA applies to a small business debtor, which phrase includes individuals, partnerships, and corporations, subject to a particular debt limit of the entity. The SBRA added provisions to Chapter 11, applicable to these small business debtors. Like typical Chapter 11 cases, a small business debtor can confirm a plan with the approval of its creditors—consensually. 11 U.S.C. § 1181. If everyone’s getting along, the debtor gets its discharge under the standard discharge provision of 11 U.S.C. § 1141(d). 11 U.S.C. § 1181(c). Or the debtor can confirm the plan without the consent of its creditors, via the vivid, yet apt “cramdown” method. 11 U.S.C. § 1191. If the small business debtor is cramming down its plan, the discharge it gets is found in 11 U.S.C. § 1192, rather than 11 U.S.C. § 1141.

So, what’s the difference between § 1141 and § 1192?

Section 1141(d)(2) states: “A discharge under this chapter does not discharge a debtor who is an individual from any debt excepted from discharge under section 523 of this title.”

Section 1192, in contrast, states: “If the plan of the debtor is confirmed under section 1191(b) . . . the court shall grant the debtor a discharge of all debts . . . , except any debt— . . . (2) of the kind specified in section 523(a) of this title.

Missing from § 1192, but present in § 1141, then, is a reference to “an individual”. Thus, the question becomes, was that an intentional maneuver of Congress to make § 523(a) debts excepted from discharge in a business Subchapter V, Chapter 11 case, if the debtor confirms its plan via the “cramdown” method?

The Bankruptcy Court’s Analysis and Conclusion

The Bankruptcy Court set up the issue as follows, after noting this omission: “There is a question of whether § 1192(2)’s reference to § 523(a) applies only to individuals, or if it includes entity debtors, such as an LLC.” In re Rtech Fabrications, LLC, 2021 WL 4204800, at *2.

The Court began its analysis of this issue by noting two bankruptcy courts that had already reached this issue, despite the fact that § 1192 is a relatively new statute. Id. The Court noted that both of those courts determined that the omission was not meant to modify a business debtor’s discharge in a Chapter 11 case, and thus § 1192 operates the same as § 1141. Id. The Court agreed with these decisions.

In doing so, the Court addressed the plain language of § 523(a) and § 1192. Id. at *2-*3. The Court noted that § 523(a) itself expressly refers to “an individual debtor” whose debts would not be discharged; and thus, § 1192’s reference to that statute did not remove this requirement under § 523(a). The Court noted that § 523(a) also refers directly to § 1192. From this, the Court determined that § 1192’s reference to § 523(a) was not intended to expand the “types of debtors” whose debts are not dischargeable under § 523(a). Id. at *3. Finally, the Court determined that this reading of the applicable statutes was most consistent with the overall statutory scheme of the Bankruptcy Code’s discharge provisions in Chapter 11 to protect the corporate discharge. Id. at *3-*4.

Conclusion and Takeaways

In re Rtech Fabrications, LLC is a good reminder for creditors that a business is not subject to the “exceptions to discharge” found at 11 U.S.C. § 523(a). And this is the case even in a case under Subchapter V, Chapter 11, as the Court held. However, of course, acts of fraud and other tortious acts covered in 11 U.S.C. § 523(a) are committed by individuals, perhaps working under the guise of the company. The individuals committing those acts are likely not immune to the consequences of their actions, however. Inside and outside of bankruptcy, those claims may be pursued as against the individuals, and, if established, may provide an exception to discharge in the individual’s bankruptcy case. Competent bankruptcy counsel should be consulted to properly pursue claims in the event of the business bankruptcy involving individual fraud or other tortious acts.