In the case of Avion Funding v. GFS Industries (In re GFS Industries), 99 F.4th 223 (5th Cir. 2024), the U.S. Court of Appeals for the Fifth Circuit held that corporate debtors that elect to proceed under Subchapter V of Chapter 11 are, pursuant to Section 1192 of the Bankruptcy Code, subject to the discharge exceptions set forth in Section 523 of the Bankruptcy Code. In so holding, the GFS court agreed with the U.S. Court of Appeals for the Fourth Circuit, the only other circuit court to address this issue, in the case of Cantwell-Cleary v. Cleary Packaging (In re Cleary Packaging), 36 F.4th 509 (4th Cir. 2022).

Background

In the GFS case, the debtor, GFS Industries LLC, entered into an agreement with Avion Funding LLC. pursuant to which Avion loaned money to GFS. To secure this obligation, Avion obtained a lien on certain of GFS's future receivables. As part of the agreement, GFS represented to Avion that it did not anticipate filing for bankruptcy. However, two weeks after signing the agreement, GFS filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code in the U.S. Bankruptcy Court for the Western District of Texas. In its bankruptcy petition, GFS elected to proceed under Subchapter V of Chapter 11.

Avion filed a complaint against GFS in its bankruptcy case claiming that GFS fraudulently obtained Avion's financing by misrepresenting whether it anticipated filing for bankruptcy. In its complaint, Avion sought a declaration from the bankruptcy court that GFS's debt to Avion was nondischargeable due to these misrepresentations. GFS moved to dismiss Avion's complaint, arguing that the dischargeability exception on which Avion sought relief only applies to individual debtors.

The bankruptcy court agreed with GFS. In so doing, the bankruptcy court followed the reasoning of various other bankruptcy courts and declined to follow the Fourth Circuit's ruling in Cleary. Avion appealed the bankruptcy court's decision, and the bankruptcy court granted Avion's motion to certify a direct appeal to the Fifth Circuit.

Analysis

As did the Fourth Circuit in Cleary, the GFS court found that the purposes of Subchapter V support along with the Bankruptcy Code itself support the notion that the exceptions to a debtor's discharge under Section 523(a) of the Bankruptcy Code apply to corporate and individual Subchapter V debtors alike, and not just to individual Subchapter V debtors. Although the GFS court acknowledged that this issue is complicated by a "textual awkwardness" in the Bankruptcy Code, it ultimately sided with the Fourth Circuit.

According to the Fifth Circuit, the "textual conundrum" arises from the preamble in Section 523(a). This preamble states, among other things, that a discharge under Section 1192, which applies in Subchapter V cases, "does not discharge an individual debtor from any debt." The bankruptcy court found this preamble to be critical and to require the conclusion that, in Subchapter V, the discharge exceptions apply only to an individual debtor. However, the Fifth Circuit found that putting controlling weight on the word "individual" in Section 523(a) disregards the plain language of Section 1192(2).

The GFS court explained that Section 1192 does not distinguish between individual and corporate debtors. Rather, this section simply provides for the discharge of debts of a debtor, "plain and simple." Because a "debtor" in Subchapter V cases means a "person" engaged in commercial or business activities with a debts not exceeding $7.5 million, and a "person" is, in turn, is defined by the Code to include both individuals and corporations, Section 1192 applies to both individual and corporate debtors.

The GFS court also emphasized that Section 1192 excepts from a Subchapter V debtor's discharge "any debt … of the kind specified in Section 523(a)." The court stated that it "must apply this precise language as written," and that the "most natural" reading of Section 1192 is that it subjects both corporate and individual Subchapter V debtors to the kinds of debt excepted from a discharge under Section 523(a). The court also reiterated that Section 1192 does not refer to any kind of debtor. Had Congress intended to make a distinction between individual and corporate debtors in Section 1192, it would have done so, and the GFS court found that courts cannot read the text of Section 1192 any differently.

The Fifth Circuit also addressed two relevant cannons of statutory construction: the "general/specific canon" and the "surplusage canon." With the respect to the former canon, the Fifth Circuit found Section 1192 to be the more specific provision. As such, to the extent Section 523(a) and Section 1192 clash, Section 1192 must control. The Fifth Circuit also found this canon to be "especially applicable" where, as with Subchapter V, Congress has enacted a "comprehensive scheme and has deliberately targeted specific problems with specific solutions." With respect to the latter canon, while the Fifth Circuit agreed that, if possible, every word of a statute should be given effect, this is not absolute. The GFS court explained that there are many examples of superfluous language in the Bankruptcy Code, and that the use of the word "individual" in Section 523(a) cannot be read to implicitly modify the plain language of Section 1192.

The Fifth Circuit found further support for its holding in the larger context of the Bankruptcy Code and the purposes of Subchapter V. According to the GFS court, its interpretation of Section 1192 is consistent with existing interpretations of the "virtually identical" discharge provision in Chapter 12. The court also found that its interpretation respects the "compromise" that Congress made in enacting Subchapter V.

As the GFS court explained, in creating Subchapter V, Congress sought to help small business debtors by abrogating the "absolute priority rule" that applies in standard Chapter 11 cases. Under this rule, a Chapter 11 debtor can only confirm a nonconsensual plan if classes of creditors are paid in full before any junior class of creditors. But, in Subchapter V cases, a debtor can confirm a nonconsensual plan without satisfying the absolute priority rule so long as the plan ensures that all of the debtor's disposable income is paid to creditors for three to five years. According to the GFS court, to "counterbalance" this, Congress excepted from a Subchapter V debtor's discharge any debt "of the kind" specified in Section 523(a). In other words, Subchapter V is a compromise in which small business debtors are afforded a "benefit" in the form of an exception to the absolute priority rule while also subjected to a "punishment" in the form of Section 523(a)'s discharge exceptions.

Thus, the Fifth Circuit agreed with the Fourth Circuit that Section 1192 subjects both corporate and individual debtors that elect to proceed under Subchapter V to the categories of debt excluded from the discharge under Section 523(a).

Conclusion

As of the writing of this article, the Fifth and Fourth circuits are the only courts of appeals to decide the issue of whether a corporate Subchapter V debtor is subject to the discharge exceptions under Section 523(a). The majority of bankruptcy courts and the U.S. Bankruptcy appellate panel for the Ninth Circuit have all ruled the other way. Perhaps the next court of appeals to take on this issue will agree with these lower courts' decisions, creating a circuit split. However, putative debtors seeking to reorganize should be mindful of this growing area of case law as they weigh their different reorganization options including, whether, and where, to proceed under Subchapter V.

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