Update: Fourth Circuit Rules that Non-dischargeability Provisions of Section 523(a) of the Bankruptcy Code Applicable to Corporate Debtors Under Subchapter V of the Small Business Reorganization Act.

On June 7, 2022, the Fourth Circuit ruled that the non-dischargeability provisions of Section 523(a) of the Bankruptcy Code were applicable to corporate debtors under Subchapter V of the Small Business Reorganization Act.

In his previous post from March, we discussed the case of Cantwell-Cleary Co., Inc. vs Cleary Packaging, LLC (In re Cleary Packaging, LLC), which was then pending before the Fourth Circuit Court of Appeals. As background, Cantwell-Cleary Co., Inc. had obtained a $4.7 million jury verdict against Cleary Packaging, LLC for, among other thing, tortious interference with its customer and employee contracts. Cleary Packaging, LLC thereafter filed for bankruptcy protection under Subchapter V of Chapter 11 of the Bankruptcy Code.
After the bankruptcy, Cantwell-Cleary Co., Inc. filed an adversary proceeding to hold its judgment non-dischargeable under section 523 of the Bankruptcy Code, arguing that Cleary Packaging, LLC had caused willful and malicious injury to Cantwell-Cleary Co., Inc.
In a traditional Chapter 11, section 523 of the Bankruptcy Code would not be applicable. However, the Small Business Reorganization Act added Section 1192 of the Bankruptcy Code, which provides, in relevant part, that in the case of a nonconsensual plan, the bankruptcy court shall grant the debtor a discharge of all debts … except any debt “of the kind specified in section 523(a) of [title 11]” (emphasis added). Notably, Section 1192 does not differentiate between an individual and corporate debtor. However, section 523 of the Bankruptcy Code by its terms applies only to individual debtors. Based on the language of section 523 of the Bankruptcy Code, the United States Bankruptcy Court for the District of Maryland held that the discharge exceptions enumerated in Section 523(a) of the Bankruptcy Code did not apply to a corporate debtor proceeding under Subchapter V.

Cantwell-Cleary Co., Inc. appealed directly to the Fourth Circuit Court of Appeals. On June 7, 2022, the Fourth Circuit issued a published opinion reversing the ruling of the Bankruptcy Court. A link to the published opinion (the “Opinion”) is below. The Fourth Circuit focused first on the language of 11 U.S.C. § 1192(2). The Fourth Circuit noted that 1192 focused on the type of debt specified by section 523 of the Bankruptcy Code, not the type of debtor. Opinion at p. 10. The Fourth Circuit noted that section 1192 was the more specific provision only applicable to SubChapter V, and thus should take precedence over section 523 of the Bankruptcy Code. Opinion, p. 11. Further, in the context of subchapter V, where creditor voting rights are limited and the absolute priority rule is abrogated, the Fourth Circuit held that finding 523 applicable to subchapter V debtors “provide[s] an additional layer of fairness and equity to creditors to balance against the altered order of priority that favors the debtor”. Opinion at 15.

The Fourth Circuit Opinion is a victory for creditors who have been defrauded or who are the victims of intentional torts. Debtors who have committed such wrongdoing cannot now threaten to file for SubChapter V, keep their equity in their companies, and pay creditors pennies on the dollar. A debtor in such a situation will now either have to win the votes of their creditors or subject themselves to traditional chapter 11 with its increased protections for creditors, including the absolute priority rule, the right to file a creditor plan, and enhanced voting rights.

McNamee Hosea partners Steven Goldberg and Justin Fasano filed Cantwell-Cleary Co., Inc.’s appellate briefs before the Fourth Circuit. The appeal was argued by Justin Fasano.