Rudolph J. Di Massa Jr.

Drew S. McGehrin

Introduction

In In re Ellingsworth Residential Community Association, the U.S. Bankruptcy Court for the Middle District of Florida determined that a nonprofit community association engaged in the requisite "commercial or business activities" sufficient to qualify it as a "small business debtor" for purposes of filing a Chapter 11 petition under Subchapter V of the Bankruptcy Code. In so holding, the court determined that "any person who conducts a business or commercial enterprise is a small business debtor," interpreting the eligibility for relief under this provision broadly. If other courts follow the rationale of the Ellingsworth court, we could soon be witness to a widespread application of Subchapter V of the Bankruptcy Code as the effects of the global COVID-19 pandemic ripple into the future.

Overview of Subchapter V

Subchapter V of the Bankruptcy Code, created under the Small Business Reorganization Act of 2019 (the SBRA), was enacted with the goal of making more attainable the benefits of the Bankruptcy Code for small businesses by streamlining what are otherwise often cumbersome and expensive Chapter 11 procedures. For example, proceedings under this subchapter do not require a debtor to file a disclosure statement, and many of the bankruptcy case milestones written into the code are subject to stricter timelines to drive the case more quickly and efficiently towards resolution.

Perhaps most substantively, however, is the Subchapter V elimination of the requirements of the "absolute priority rule." Under the absolute priority rule, an equity interest holder may not retain its equity in the reorganized debtor unless: unsecured creditors are paid in full or otherwise consent; or the equity interest holder gives "new value" to the estate. Under Subchapter V, however, these rules do not apply; rather, debtors may confirm a plan without creditor support and still retain property, even though their unsecured creditors are not paid in full.

Another important (though temporary) highlight for would-be Subchapter V filers comes from the CARES Act (the Coronavirus Aid, Relief and Economic Security Act of 2020), passed in March in response to the worldwide outbreak of the novel coronavirus. The CARES Act provides for an increase, until March 2021, in the debt limit for eligibility under Subchapter V from $2,725,625 to $7,500,000 in noncontingent, liquidated debts, thereby expanding the universe of potential debtors eligible for the benefits of Subchapter V.

Background of the Case

Ellingsworth Residential Community Association, a nonprofit community organization, filed its voluntary petition for Chapter 11 relief under Subchapter V of the Bankruptcy Code. Upon the filing, one of the debtor’s unsecured creditors, Alice Guan, objected to the requested relief, alleging that Ellingsworth was not an eligible debtor under Subchapter V: Guan argued that, as a non-profit community association, Ellingsworth did not engage in the requisite "commercial or business activities" provided in Subchapter V, and therefore did not qualify as a debtor thereunder.

Opinion of the Bankruptcy Court

In analyzing the creditor’s contentions, the bankruptcy court initiated its inquiry with the language of the applicable statute. Bankruptcy Code Section 1182(1) limits those who can request relief under Subchapter V to "small business debtors." The Bankruptcy Code defines a small business debtor as 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. . .in an amount not more than $2,725,625," (which limit, as noted above, has been increased to $7,500,000 until March 27, 2021). As such, the threshold issue for the bankruptcy court was whether a non-profit community organization like the debtor conducted "commercial or business activities" of the type that would qualify it as a small business debtor.

The bankruptcy court concluded that the statute was clear and unambiguous: recognizing that the code does not define the phrase "commercial or business activities," the court had no problem construing the phrase broadly, and determined that any person conducting a business or commercial enterprise qualifies as a small business debtor eligible for relief under Subchapter V.

The court opined that, should Congress have intended otherwise, it could have chosen different terms or added express exclusions with respect to the universe of potential Subchapter V debtors. Instead, the court found that the express language of the code’s definition of "small business debtor" evidences Congress’ intent to include persons engaged in a very wide range of commercial or business activity. The court explained, however, that such activity does not include endeavors of a personal, family or household nature.

The court found that the Ellingsworth debtor engaged in activities that were clearly of a business nature: the debtor contracted for goods and services; it hired employees and professionals; it oversaw common area property; it engaged maintenance and landscaping services; and it filed regular tax returns and listed "business income" on those returns. Additionally, the court made note of the facts that the debtor was registered as a corporation with the state of Florida, had a board of directors, and collected regular and special assessments from its member homeowners. The court found these activities to suffice as the requisite business and commercial activities necessary for qualification under Subchapter V.

Perhaps the objecting creditor’s most appealing argument lay in her observation that, as a nonprofit entity, the debtor in this case lacked a profit motive. She referred the court to Sections 303(a) and 1112(c) of the code, both of which make reference to a company "that is not a moneyed, business, or commercial corporation." Those sections provide discrete protections to such entities: they prohibit the filing of an involuntary bankruptcy petition against, and limit the court’s ability to convert from Chapter 11 to Chapter 7 the case of, such entities. Guan noted that some courts had included non-profit corporations within the ambit of entities entitled to the protections set out in Sections 303(a) and 1112(c). As a result, she argued, non-profit corporations should not be able to avail themselves of the special benefits that Subchapter V affords "small business debtors."

Labeling Guan’s reasoning as a comparison of "apples to oranges," the court was unpersuaded by this argument. It pointed out that Code Sections 303 and 1112 simply identify the type of corporation entitled to certain protections; they do not define the actual activities (e.g. "business-related activities") of such a corporation. The court also noted that there is no statutory language purporting to preclude such a corporation from qualifying as a "small business" under Subchapter V. As such, it concluded that Sections 303 and 1112 of the code did nothing to support the argument that a non-profit entity could not qualify as a "small business" for Subchapter V purposes.

Based on this rationale, the court overruled the creditor’s objection and permitted the case to proceed under Subchapter V of the Bankruptcy Code.

Conclusion

As 2020 draws to a close, it is already evident that commercial Chapter 11 filings have been trending upward. We note that this trend may continue, with many small businesses looking to take advantage of Subchapter V while the increased debt limit is still available. While the outer limits of this new subchapter are still being drawn, courts may be keen to continue to open the door to a broader qualification of debtors seeking relief thereunder. Indeed, according to the Ellingsworth court, almost any "person" conducting a business or commercial enterprise will qualify for such relief. As such, creditors and their counsel are well-advised to acquaint themselves with the significant distinctions between a traditional Chapter 11 bankruptcy case and one commenced under Subchapter V: there are potentially impactful differences that materially alter (or entirely eliminate) certain creditor protections that would otherwise be applicable in a traditional Chapter 11 case.

Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors’ rights.

Drew S. McGehrin, an associate at the firm, practices in the areas of commercial finance, financial restructuring and bankruptcy.

Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.