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"Engaged" in Business as a Qualification for Subchapter V - Commercial & Bankruptcy Law News

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Commercial & Bankruptcy Law News


Posted on: Mar 12, 2021

By Amy L. Elson, Blackwell, Burke & Ramsey PC

Subchapter V, which was added to the Bankruptcy Code by the Small Business Reorganization Act of 2019 and became effective on February 19, 2020, established framework for small businesses to seek reorganization by filing for bankruptcy protection under a specific subset of statutory provisions designed to decrease the costs (both in terms of time and money) associated with a traditional Chapter 11 filing.  The provisions of Subchapter V, which were noteworthy at the time of their enactment, have become even more impactful for eligible small businesses seeking Subchapter V reorganization during the COVID-19 pandemic; Congress has expanded eligibility pursuant to the CARES Act to include businesses reaching an applicable debt limit of $7.5 million (a marked increase from the statute’s original $2,725,625 limit).  Subchapter V offers an attractive reorganization vehicle for a small business—provided that the business can qualify as a “small business debtor.”  The question of which attributes qualify a prospective Subchapter V debtor as a “small business debtor” has recently received another round of analysis from bankruptcy courts, and the most recent answer to this question deepens the debate not only about which businesses qualify, but also hints as to how bankruptcy courts may interpret the definition to allow businesses affected by the COVID-19 pandemic to avail themselves of Subchapter V’s protections.  

11 U.S.C. §101(51D) defines a “small business debtor,” among other qualifications, as “…a person engaged in commercial or business activities….”  The interpretation of this definition has thus far hinged on the pivotal word “engaged,” a term that has been interpreted differently by bankruptcy courts determining debtors’ eligibility for Subchapter V.  Judge Norton of the United States Bankruptcy Court for the Western District of Missouri has interpreted this term to require that debtors be currently engaged in business on the petition date—debtors who had sold the subject business with no intent to return to it and had no present commercial or business activities could not qualify as small business debtors, even though the subject business maintained its filing status with the Missouri Secretary of State.  In re Thurmon, 69 Bankr. Ct. Dec. 165, 2020 WL 7249555 (Bankr. W.D. Missouri, December 8, 2020).  In contrast, Judge Burris of the United States Bankruptcy Court for the District of South Carolina has interpreted the term “engaged” to permit a defunct business to qualify as a small business debtor.  Judge Burris found no statutory requirement that debtors be currently engaged in business or commercial activities and that a debtor can qualify as a small business debtor because the debts arose from business operations.  In re Wright, 2020 WL 2193240 (Bankr. D. South Carolina, April 27, 2020).  

The most recent interpretation of “engaged” comes from the United States Bankruptcy Court for the Northern District of Texas.  The Debtors in In re Cord David Johnson and Sunny Lea Johnson, who sought to convert their Chapter 7 filing to a Chapter 11 filing contingent on their ability to qualify for Subchapter V eligibility, argued that “engaged” should be interpreted expansively to include prior ownership and management. The Debtors’ debts arose from liabilities associated with their prior ownership and management of several oil and gas companies that were defunct as of the Debtors’ petition date.  Debtors’ creditors objected to Debtors’ efforts to qualify for Subchapter V on the grounds that the Debtors did not meet the definition of small business debtor because they were not “actively carrying out” commercial or business activities on the petition date. Judge Morris declined to apply the interpretation offered by the creditors because it was too narrow, but he also declined to apply Debtors’ expansive interpretation of the word “engaged,” finding instead that the word is “inherently contemporary in focus” and requires consideration of a would-be Subchapter V debtor’s “current state of affairs.”  In re Cord David Johnson and Sunny Lea Johnson, 2021 WL 825156 (Bankr. N.D. Texas, March 1, 2021).  

This case evidences the continuing split among bankruptcy courts regarding the interpretation of the gateway definition of “small business debtor.”  Even more importantly, though, Judge Morris’ opinion opens the door to consideration of how the definition of “engaged” might change with reference to its application to a debtor seeking Subchapter V status due to business disruptions caused by the COVID-19 pandemic.  Specifically, Judge Morris rejected the creditors’ interpretation of the definition of engaged—i.e., “actively carrying out” commercial or business activities—precisely because it was too narrow to account for businesses whose operations have been affected by the pandemic:

Consider, for example, the situation where a debtor has been forced to temporarily cease operations for unexpected non-financial reasons, such as weather, a natural disaster, or to comply with regulatory requirements.  Many small businesses have recently experienced this very situation, having been ordered to temporarily cease operations on account of the COVID-19 pandemic.  While these very same businesses planned to (and most often did) reopen once permitted, had they filed for bankruptcy protection while temporarily shut down, the Objectors’ proposed test would have precluded them from being eligible for subchapter V relief because they were not actively carrying out commercial or business activity as of the date of the bankruptcy filing.

Id., FN 28.

The opinion in In re Cord David Johnson and Sunny Lea Johnson demonstrates that qualification as a “small business debtor” per 11 U.S.C. §101(51D) may be a qualification that is established by very fact-sensitive inquiry.  There is currently a split among bankruptcy courts that have considered whether there is a temporal component embedded within the meaning of “engaged.” Moreover, it appears that there may now be an additional layer for consideration—namely, what are the circumstances surrounding whether the debtor meets the temporal component of engaged?  The court’s opinion in In re Cord David Johnson and Sunny Lea Johnson suggests that the analysis of temporality may also incorporate a situational analysis that should be considered by debtors and creditors within their respective Subchapter V eligibility analyses, especially for those small businesses whose petition for Subchapter V has arisen as a result of the COVID-19 pandemic.  
 

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