Appellate court rules that subchapter V small business debtors don’t need to be for profit businesses

By Zev Shechtman

In re RS Air, LLC, __ B.R. __, 2022 WL 1288608 (B.A.P. 9th Cir. April 26, 2022)

Case Synopsis

In order to qualify for small business reorganization under subchapter V of chapter 11 of the Bankruptcy Code, a debtor must be “engaged in commercial or business activities.”  In this case, the Bankruptcy Appellate Panel of the Ninth Circuit determined that a debtor does not need to have a “profit motive” in order to be “engaged in commercial or business activities” within the meaning of the Bankruptcy Code.

Introduction

In this case, the BAP affirmed the bankruptcy court’s order overruling the objection of appellant NetJets to subchapter V designation.  NetJets argued that the debtor was not eligible for subchapter V relief because it was not “engaged in commercial or business activities” within the meaning of section 1182(1)(A) of the Bankruptcy Code.  NetJets argued that the debtor was not “engaged in commercial or business activities” because it did not have “profit motive.”  The bankruptcy court disagreed with NetJets, finding that a profit motive is not necessary to establish that a debtor is engaged in commercial or business activities.  NetJets also argued that the bankruptcy court erred by determining that the objecting party had the burden of proof on subchapter V eligibility and by failing to consider exceptions to the “law of the case” doctrine.  While the BAP generally agreed with NetJets on those issues, the BAP found that those errors were harmless.

Facts

RS Air was an LLC used by its sole member, Stephen Perlman, for personal benefits, such as aircraft transportation services, acquiring and selling interests in aircraft, and to depreciate taxes.  RS Air had agreements with NetJets to purchase fractional interests in private jets.  RS Air and NetJets had a falling out resulting in a lawsuit wherein NetJets alleged breach of contract and RS Air counterclaimed for breach of contract and fraud.  As a result of these disputes, RS Air ceased normal flight operations and ended up filing for subchapter V chapter 11 bankruptcy prior to trial.  NetJets was a creditor with 98% of non-insider debt.

NetJets objected to RS Air’s subchapter V designation.  NetJets argued that RS Air was not engaged in “commercial or business” activities as of the petition date, as required for eligibility, because RS Air had no flight operations, no income or revenue, no employees, and its sole purpose was as a company through which Perlman could acquire interests in and use private jets.  RS responded, arguing that it was engaged in commercial or business activities by: (1) litigation with NetJets, (2) negotiating transactions with NetJets, (3) paying aircraft registry fees, (4) remaining in good standing as a Delaware LLC, and (5) keeping current on state and federal taxes.

The bankruptcy court ruled that it was movant’s, not debtor’s, burden of proof on an objection to subchapter V eligibility.  Then, the bankruptcy court found that RS Air was engaged in commercial or business activities, because RS Air: (1) was engaged in the business of litigation with NetJets, (2) intended to resume operations, (3) paid aircraft registry fees, (4) remained in good standing as a Delaware LLC, and (5) filed and paid taxes.  The bankruptcy court therefore determined that NetJets failed to meet its burden of proof and overruled the objection.

NetJets later objected to plan confirmation, again arguing that the debtor was not eligible to be a subchapter V debtor.  The bankruptcy court decided that the law of the case doctrine precluded re-litigation of eligibility.  But, in any event, the bankruptcy court also noted that a growing body of case law supported the bankruptcy court’s early ruling.  NetJets appealed.

BAP Ruling

The BAP ruled that the bankruptcy court did not err in determining that RS Air was engaged in commercial or business activities.  The BAP cited a majority of courts which have determined that a debtor does not need to be “actively operating” in order to satisfy the requirement of being “engaged in commercial or business activities.”  Rather, the BAP held that a debtor must be “presently” engaged in “some type of commercial or business activities to satisfy § 1182(1)(A).”  The BAP cited approvingly cases that considered a “totality of circumstances” approach to the question of what constitutes commercial or business activities.

The BAP disagreed with NetJets that a “profit motive” is necessary to establish the existence of commercial or business activities.  The BAP found that the tax beneficial aspects of the company constituted “business” within the common meaning of that term.  Further, the BAP cited a number of cases of nonprofit entities, including churches, hospitals, and other nonprofits, which were eligible for subchapter V relief.

After dispensing with the appellant’s argument on the merits, the BAP addressed the burden of proof.  The BAP found that the bankruptcy court erred when it determined that it was the movant’s, not the debtor’s, burden to establish eligibility.  The BAP agreed with the majority of courts which have examined the issue and determined that it is the debtor’s burden to establish eligibility.  However, the bankruptcy court’s error was harmless since RS Air demonstrated in opposition to the objection to eligibility that it was engaged in commercial or business activities as required by the Code.

Finally, the BAP acknowledged that the bankruptcy court failed to consider exceptions to the law of the case doctrine when it overruled the objection to eligibility when it was raised for a second time at plan confirmation.  NetJets asserted that new evidence further established that the debtor never had any profits.  The BAP held that any failure to consider such exceptions was harmless since all of the new evidence presented by NetJets related to its erroneous argument that a profit motive was necessary to establish subchapter V eligibility.  Such evidence would not have changed the outcome.

 

Bankruptcy Appellate Decision Subordinates Judgment Liens Under Section 510(b)

By Eric P. Israel and Alphamorlai “Mo” Kebeh

Recently, the Bankruptcy Appellate Panel for the Ninth Circuit (the “BAP”) issued a ruling on an important issue.  In Kurtin v. Ehrenberg (In re Elieff), 637 B.R. 612, 2022 WL 832417 (B.A.P. 9th Cir. March 21, 2022), the BAP ruled that, when a claim is subordinated under Section 510(b), any judgment and other liens and encumbrances securing said claim are subordinated as well.  The BAP analyzed this issue in the context of a dispute between Todd Kurtin and Bruce Elieff, two former business partners embroiled in litigation.

Before the bankruptcy filing, the two parties reached a settlement agreement whereby, in relevant part, Kurtin would transfer his ownership interest in their business entities and, in exchange, Elieff would effect a series of settlement payments from the funds of such entities.  Elieff ultimately breached the settlement agreement, and Kurtin initiated a lawsuit against Elieff, alleging a breach of contract and other causes of action.  A jury returned a verdict on the breach of contract claim in favor of Kurtin, who subsequently recorded two abstracts of judgment against Elieff.  Elieff then filed a chapter 11 petition for bankruptcy and commenced an adversary proceeding against Kurtin, alleging subordination of claims under section 510(b).  The bankruptcy court granted summary judgment on the section 510(b) claims in favor of the plaintiff, and appeal was taken to the BAP.

The BAP determined that Kurtin’s claim for breach of the settlement agreement arose from the purchase or sale of securities, per section 510(b) of the Bankruptcy Code.  In doing so, the BAP noted that “[t]he Ninth Circuit broadly interprets the scope of § 510(b)” and that a claim arises from the purchase or sale of securities “whenever it shares a ‘nexus or causal relationship’ with the purchase or sale of securities.”  Because Kurtin’s claim indisputably originated from the breach of the settlement agreement which contemplated the transfer or sale of securities, the BAP found no material difference between the matter before it and other cases in which the Ninth Circuit had found that subordination was appropriate under Section 510(b).

After an in-depth analysis, the BAP in Elieff concluded that Kurtin’s judgment liens also should be subordinated under section 510(b).  First, turning to the definition of “claim” under section 101(5), the BAP determined that subordination of a “claim” within the meaning of Section 510(b) encompasses the entirety of a right to payment, “whether personal or in rem,” meaning that Kurtin would not be entitled to “any right to payment from any means until the unsecured creditors in the case were paid in full.”  It noted that the definition of “claim” in section 101(5) included any right to payment, “secured or unsecured.”  From a policy perspective, the BAP found that interpreting the word “claim” differently would lead to incongruous results, primarily because doing so “would permit a former equity investor to elevate its lien rights ahead of the unsecured creditors § 510(b) was enacted to protect.”  For these reasons, the BAP found that subordination of Kurtin’s claim was required under section 510(b), and that “once the claim has been subordinated, the lien automatically follows the debt.”

In re Elieff is a BAP decision with a clear ruling on an otherwise murky issue in bankruptcy law:  whether section 510(b) applies to subordinate judgment liens or only the underlying unsecured claim.  This subordination applies regardless of the date of creation or perfection of the judgment liens, which might otherwise be limited to a 90 day preference window.  Additionally, it provides considerable insight as to the type of claims that are subject to mandatory subordination under 11 U.S.C. § 510(b).  While we understand that Elieff has been appealed to the Ninth Circuit Court of Appeals, bankruptcy practitioners should be aware of this decision and its potential implications in their practice.

Subchapter V Debt Limit Likely to Sunset at the End March

The subchapter V debt limit is likely to revert to $2,725,625 on March 28, 2022. Hope remains that Congress will soon restore it to $7.5 million.

By Aaron E. de Leest, Danielle R. Gabai, and Zev Shechtman

On March 28, 2022, the provision in the Coronavirus Aid, Relief, and Economic Security Act or the “CARES Act,” which increased the eligible debt limit for subchapter V debtors to $7,500,000 will sunset, and the debt limit will revert to $2,725,625.  The Senate has made efforts to remove the sunset provision in the CARES Act and thereby permanently increase the debt limit to $7,500,000.  However, the Senate’s bill, which was introduced on March 14, 2022, is stalled in the Senate Judiciary Committee.  Because the House is not in session this week, it does not appear that the Senate’s bill will make it through Congress and onto the President’s desk before the March 28, 2022 sunset.  Therefore, it is likely that, at least for the short term, the debt limit for subchapter V debtors will be substantially reduced to $2,725,625.

 

What does this mean for small businesses? 

Subchapter V provides a streamlined, less expensive, chapter 11 reorganization process for small business debtors.  See our prior blog post: https://danninggill.com/the-small-business-reorganization-act-of-2019-sbra/.   When Congress created subchapter V, it made $2,725,625 the maximum amount of debt that a debtor could owe and be eligible for subchapter V.  In response to the Covid-19 pandemic, in March 2020, Congress increased the limit to $7.5 million, but the limit expired after one year.  In 2021, Congress extended the higher debt limit to March 27, 2022.  When the higher cap expires, businesses will be ineligible to file subchapter V if they have more than $2,725,625 in debt.  To seek reorganization in bankruptcy, those debtors will need to file for regular chapter 11.

Recent Case Adds to Trend of Courts Allowing Bankruptcy Trustees to “Look Back” as Far as 10 Years to Avoid Transfers When the IRS is a Creditor

In the recent case of Mitchell v Zagaroli, 2020 WL 6495156 (Bankr. W.D.N.C. 2020), 2020 WL 6495156 (Bankr. W.D.N.C. 2020), the bankruptcy court ruled that a chapter 7 trustee under 11 U.S.C. § 544(b) could “step into the shoes” of the IRS as an actual creditor to avoid a fraudulent transfer of property occurring up to ten years prior to the petition date.

Under section 544(b) of the Bankruptcy Code, the trustee of a bankruptcy estate may “avoid” (or colloquially, “claw back”) certain transfers of property.  According to section 548 of the Bankruptcy Code, the reach back period for the trustee prior to the bankruptcy filing to avoid transfers is two years.  However, section 544(b) allows a trustee to avoid any fraudulent transfer “that is voidable under applicable law by a creditor holding an unsecured claim.”  Generally, this has been applied to a trustee employing avoidance powers under applicable non-bankruptcy law (i.e. State law), typically extending the look back period by a few years.  In Zagaroli, the Court ruled that, if the IRS is an unsecured creditor of the bankruptcy estate, the look back period may extend to ten years prior to the petition date.

In Zagaroli, the debtor allegedly transferred multiple parcels of real property to his parents for no consideration in December 2010 and June 2011.  In May 2018, the debtor filed a chapter 7 petition.  The IRS filed a proof of claim in the debtor’s case.  Thereafter, the trustee filed an action to avoid the debtor’s 2010 and 2011 transfers to his parents.  The trustee claimed that section 544(b) allowed the trustee to use section 6502 of the Internal Revenue Code to avoid transfers as far back as ten years before the debtor’s petition filing.

To determine the merits of this claim, the court relied on the plain meaning of Bankruptcy Code section 544(b).  As the IRS had an unsecured claim in the debtor’s estate, the court determined that the plain language of section 544(b) allowed the trustee to “step into the shoes” of the IRS (an “actual creditor”) and use section 6502 of the Internal Revenue Code to avoid the debtor’s real estate transfers.  To support this conclusion, the court relied heavily on In re Gaither, 595 B.R. 201 (Bankr. D.S.C. 2018), which determined that section 544(b) similarly permitted the trustee to step into the IRS’s shoes and that courts should not look beyond the plain meaning of this provision.  Zagaroli cited other cases as well and characterized this as the “majority rule.”

It does appear that the majority of cases in the nation ruling on this issue have come to the same conclusion as Zagaroli, though some courts have disagreed.  For example, in In re Vaughan Co., 498 B.R. 297 (Bankr. D.N.M. 2013), the court relied more heavily on congressional intent and determined that a trustee should not be permitted to use the unique powers of the IRS.  The Vaughan Co. court opined that the federal government was not meant to be used as a “mere conduit for the enforcement of private rights which could have been enforced by the private parties themselves.”  Id. at 304 (citing Marshall v. Intermountain Elec. Co., 614 F.2d 260 (1980)).  Thus, under this court’s analysis, a trustee could step into the IRS’ shoes but would still be barred by the state’s statute of limitations, unlike the IRS.  Id. at 305.

Despite the few opposing decisions, the holding in Zagaroli suggests that courts are continuing to extend trustees’ avoiding powers by extending the look back period when the IRS is an unsecured creditor of the bankruptcy estate.  At this time, however, there is no binding authority on this issue from the Ninth Circuit.

Debtors Beware: Exemption Planning in California Now Subject to Challenge

Nearly two decades after the Ninth Circuit ruled that debtors could protect their assets from creditors by converting them to exempt status before they file for bankruptcy, the Court of Appeals for the Second District of California has determined that such a transmutation may be challenged as a fraudulent conveyance under California law.

In Nagel v. Westen, 59 Cal. App. 5th 740 (2021), Nicole Nagel (“Nagel”) received a 4.5 million dollar arbitration award against Tracy Westen and Linda Lawson (“Sellers”) as a result of the Sellers’ failure to disclose material facts about a home they sold to Nagel.  To protect their assets, the Sellers applied the proceeds of the sale to a home in Texas (with a high homestead exemption) and a variety of investments in Nevada and Minnesota.  In response, Nagel sought to unwind those transactions under California’s Uniform Voidable Transactions Act (“UVTA”).

The primary issues before the court were: (a) whether the Sellers’ transactions constituted “transfers” within the meaning of the UVTA, and (b) if they were transfers, whether those transfers were fraudulent.  The trial court dismissed the claims as failing to state a claim for relief, and this appeal followed.  The appellate court noted that the UVTA defines “transfer” as “every mode . . . of disposing of or parting with an asset or an interest in an asset.” Cal. Civ. Code § 3439.01, subd. (m).  The court in Nagel determined that physically relocating property and transmitting sale proceeds out of state and then transmuting the proceeds into a different form is a mode of “parting with assets,” constituting a transfer per the definition in the UVTA.  Nagel, 59 Cal. App. 5th 740.  To support its reasoning, the court further explained that manipulating property to evade creditors would contravene the UVTA’s stated purpose “to prevent debtors from placing, beyond the reach of creditors, property that should be made available to satisfy a debt.”  Nagel distinguished as dicta language from the California Supreme Court in Kirkeby v. Superior Court, 33 Cal. 4th 642, 648 (2004), that a “transfer” requires the conveyance of an interest to a third party.  Id. at 648.

We believe that the decision in Nagel does not bear on the Supreme Court’s decision in Law v. Seigel, 571 U.S. 415 (2014).  There, the Supreme Court ruled that trustees may not rely on federal law to deny an exemption on grounds outside the scope of the Bankruptcy Code, but they may apply state law to disallow state-created exemptions.  Id. at 425.  It does, however, conflict with the Ninth Circuit’s ruling in Gill v. Stern (In re Stern), 345 F.3d 1036, 1045 (9th Cir. 2003), which held that the conversion of a debtor’s assets from non-exempt to exempt status on the eve of bankruptcy is not sufficient to qualify as a fraudulent transfer as a matter of law.

This decision could significantly affect a debtor’s strategies before filing for bankruptcy.  The practice of exemption planning, whereby debtors organize their financial assets to maximize the amount of property protected in bankruptcy, must be done more circumspectly following Nagel.

Ravn Alaska’s Emergence from Bankruptcy

From Float Alaska to the New Ravn—Acquiring Alaska’s Largest Regional Airline through Bankruptcy During the COVID-19 Pandemic

In March of 2020, Ravn Air Group, Inc. and its seven affiliates (collectively, Ravn) comprised the largest regional air carrier in the State of Alaska.  Ravn had 1,300 employees, 72 aircraft, 21 hub airports, and 73 facilities serving 115 destinations in Alaska, with 400 daily flights.  In addition to transporting passengers throughout the state, Ravn provided logistics, mail, charter, medical and freight air services in Alaska.  Ravn operated two Part 121 FAA certificates, and one Part 135 FAA certificate.  The Ravn affiliates were assembled and owned by a group of private equity firms and other investors.

In 2015, Ravn entered into a secured credit agreement with secured lenders for a term loan of up to $95 million and revolving loans of up to $15 million.  In March 2020, Ravn owed the secured lenders approximately $91 million.  All of Ravn’s assets were pledged as collateral to secure the loans.

Due to the seasonal nature of Alaska air travel, Ravn relied heavily on spring and summer bookings.  In March of 2020, the COVID-19 pandemic upended the business.  By March 12, 2020, the World Health Organization declared COVID-19 a pandemic, and the first case of the virus was announced in Alaska.  Travel restrictions, cancellations and decreased booking resulted.  By March 20, 2020, the State issued a travel advisory to cease all non-essential travel.  By the end of March 2020, Ravn lacked cash to fund operations, including payroll.

On April 5, 2020, the eight Ravn entities filed for chapter 11 bankruptcy protection in Delaware bankruptcy court.  The Ravn debtors obtained superpriority secured financing from their prebankruptcy lenders, with such debt being repaid ahead of other debts, and a limited budget available for the administration of the bankruptcy cases.  The debtors originally sought to reorganize in chapter 11 utilizing funds made available under the CARES Act, but the debtors’ secured debt burden proved too great.

The debtors’ agreement with their DIP lenders required an accelerated timeline to confirm a liquidating chapter 11 plan.  The plan also allowed for sales of assets under section 363 of the Bankruptcy Code outside of a liquidating trust, so long as the secured lenders consented to the sale.

The debtors started a sale process, with the initial intent of selling the entire business as a going concern.  The debtors solicited bids.  However, no bidder submitted a bid that the lenders deemed adequate to acquire all of the assets of the debtors.  Accordingly, the debtors sold the Ravn assets in over two dozen lots, comprised of aircraft, ground support equipment, real estate, parts and equipment, contractual rights and other personal property.

FLOAT Alaska, LLC is a company founded by Josh Jones, a startup incubator manager and investor, Tom Hsieh, an engineer and social entrepreneur, and Robert McKinney, a veteran regional airline executive.  The team previously founded FLOAT Shuttle, Inc., focused on the Southern California market.  The FLOAT Alaska team viewed the Ravn going concern sale as a unique opportunity to provide essential air services to the rural communities of Alaska and to return much needed jobs to the region.  The team also understood that a successful going concern acquisition would be accompanied by the CARES PSP grant of at least $15 million which would be used to rehire personnel and other startup costs.

The FLOAT team completed extensive due diligence on the company and its assets.  The team worked diligently to submit a qualified bid satisfying the numerous operational, financial, and procedural requirements to acquire a commercial airline.  FLOAT participated in a multiday auction with numerous competing parties vying for the going concern business.  It was a complex process where the debtors repeatedly divided, and re-divided, their assets in efforts to maximize the value.  The debtors went so far as to expressly instruct bidders to “bid against themselves,” by asking bidders to increase their offers for various assets, some of which had only one bidder.  The FLOAT Team worked indefatigably to adjust its bid to meet the requirements of the court, the debtors and creditors.

FLOAT’s ultimately successful bid for the key assets of Ravn’s passenger business was $8 million, with a waiver of major contingencies, and a firm commitment to an early and expedited closing process.  The core assets FLOAT sought to acquire included the corporate name, intellectual property and goodwill, Ravn’s Part 121 certificates, and a core fleet of six Dash-8 aircraft.  The debtors concluded that FLOAT’s carefully crafted bid was the best and highest bid for the going concern business.

In addition to the initial aircraft purchased, FLOAT acquired essential ground support equipment and several important real properties, including the debtors’ main hangar and training facility.  The FLOAT team utilized an interdisciplinary team of attorneys specialized in bankruptcy, corporate laws, aviation, and CARES Act financing, led by restructuring attorney Zev Shechtman of Danning Gill.  Because of the vision and perseverance of FLOAT’s outstanding leadership team, they were able to rapidly transition  from bidders to owners and now operators of Ravn Alaska.  The company has hired or rehired over 200 employees, and it plans to grow further.  The New Ravn will resume commercial passenger travel by the end of October. 

 

Thoughts for Small Businesses Considering Bankruptcy

For an operating business, the bankruptcy process can be time-consuming, invasive, difficult to maneuver, and expensive.  You need someone who can explain all of the options, and prepare you for what’s to come.

Rule #1:  Don’t wait until the last minute.  There are lots of things most operating companies need to do when they file for bankruptcy.  Attorneys need time to evaluate what needs to be done, gather evidence, prepare motions, and hit the ground running.  Waiting until the business is almost out of cash, or until some negative event is about to happen, hurts your ability to hire good counsel and successfully prosecute a Chapter 11 case.

When is filing for bankruptcy a good idea?

For a company, Chapter 7 (liquidation by a trustee) usually is worth doing only if the business already is closed, and if (a) there are assets that can be sold, or (b) a strong signal needs to be conveyed that the business really is defunct.  For operating businesses that have some going concern value, an orderly liquidation through Chapter 11 is a better option.

For operating companies that want to reorganize, Chapter 11 is a good idea if the business is (or can be) profitable, but needs to shed some bad leases, restructure secured loans, and/or stretch out payments to creditors.  Chapter 11 can also be good for real estate companies with property that has significant equity or can generate enough cash to make monthly interest payments.  Bankruptcy protects the debtor’s assets and gives it some time to negotiate terms with creditors.

Generally, what is the first thing a company should do if it plans to file for bankruptcy?

Especially if the company is operating, get its records (and record-keeping) in order.  From the first day to the last, the debtor’s success depends on its ability to properly identify and disclose its assets, liabilities and financial history, generate reliable financial statements during the case, and prepare realistic financial projections.  No matter how profitable a company may be, cases can go south quickly if the debtor’s financial reporting is inadequate or untrustworthy.

What should a small business expect during the first few months after filing for bankruptcy?

Petitions often are filed on the eve of a foreclosure, judgment, or other adverse event the debtor wants to delay.  But there is no rest for the weary.

Existing bank accounts must be closed and new ones opened right away.  A “7-day package” must be submitted within a week.  Detailed schedules of assets and liabilities must be filed within 15 days.  Soon after the case is filed, someone will need to attend an “initial debtor interview” and later a “meeting of creditors.”  Detailed operating reports must be filed each month.  In a Subchapter V “small business” case, the debtor must file financial statements and tax return with its petition, and generally must file a plan within 90 days.

While doing all of this (and more), the debtor must keep its business going.  For a truly small businesses, this is a monumental task.

What are some bankruptcy pitfalls that businesses should avoid?

It’s a long list.  Mostly, don’t do things that may turn the judge against you.  Don’t transfer away assets before filing.  Don’t provide false or misleading information in court filings.  Choose your battles (if you litigate about everything, the judge may see you as the problem, not the solution).

Also, don’t make everyone your enemy.  Litigating against creditors – especially secured creditors who can add their legal fees to the loan balance – drives up costs.  Often, by the time you finish fighting with a hostile creditor you will have spent more on legal fees than you would have spent if you had just agreed to pay the creditor more under a chapter 11 plan.

 

How the CARES Act Has Impacted Bankruptcy Cases

Earlier this year, we wrote about the Small Business Reorganization Act of 2019 (the “SBRA”), which went into effect on February 22, 2020.  For a quick recap on the SBRA, click here for our prior post.  In this post, we’ll discuss a few ways the CARES Act has affected bankruptcy cases.

More businesses can seek relief under the new Subchapter V of Chapter 11

One of the things the SBRA did not do was change the definition of “small business debtor” to let more businesses qualify as small business debtors under the Bankruptcy Code.  The SBRA’s proponents wanted the term “small business debtor” to include businesses with up to $10 million of debt.  But Congress rejected their request.  When the SBRA went into effect a “small business debtor” needed to have no more than $2,725,625 of “noncontingent liquidated secured and unsecured debts.”

About a month after the SBRA went into effect, Congress passed the CARES Act in response to the economic fallout of the COVID-19 pandemic.  In the CARES Act, Congress temporarily increased the debt ceiling to $7.5 million for businesses seeking relief under the new Subchapter V of Chapter 11.  As a result, we can expect to see more businesses (and individuals) qualify as “small business debtors.”

Debtors might be eligible to borrow money under the Paycheck Protection Program (PPP)

One interesting issue we’ve seen come up over the past few months is whether small businesses are eligible for PPP loans while they’re in bankruptcy. The SBA says debtors are ineligible. In fact, the official application actually told potential borrowers that their loan requests would be denied if they were in bankruptcy:

Despite the SBA’s position, some courts have held that it is illegal for the SBA to discriminate against bankrupt entities.

The last day for businesses to apply for PPP loans was August 8, 2020.  If Congress extends the application deadline, or authorizes a new round of loans, eligible businesses should consider getting PPP loans before filing for bankruptcy.

 

Wait, What? Bankruptcy Filings Have Gone Down in 2020

The CARES Act, unemployment benefits, and hope that things will reopen soon seem to have buoyed many businesses for the last four-plus months.  Landlords also have been flexible, though county and city moratoria on evictions leave them little choice.

Danning Gill partner John Tedford spoke to the Daily Journal for a July 28 article about the stats coming from the Central District of California.  Based on that information, although a number of big-name companies have been filing for bankruptcy – particularly on the east coast – locally we have not seen an upswing in bankruptcy filings.  As of mid-July, we were on pace to have about the same number of Chapter 11 business cases filed in the Central District this year as in each of the last five years. There were actually fewer filings in March, April and May than in January and February.

As of August 7, 2020, 161 Chapter 11 business cases had been filed this year.  That equates to 269 filings per year (only 4 more than last year).  In 2010-2011 there were more than 720 such cases each year.

When we look at cases filed by all debtors under all chapters, the pace of filings is way down.  As of August 7, a total of 17,828 cases had been filed in the Central District.  That equates to about 29,800 filings for the year.  Since at least 1992, the Central District has had fewer than 30,000 filings only once (in 2006), and since 2007 it has never had fewer than 37,000 filings.

As the CARES Act programs lapse, unemployment benefits decline, and threats of evictions escalate, it seems certain that bankruptcy filings will increase substantially.  Whether filings return to their 2010-2011 levels remains to be seen.

If you have access to the Daily Journal online, click here to read the full article.

Brace for Impact: Cal Supreme Court holds that the “Community Property Presumption” trumps the “Form of Title Presumption”

In November 2018 we wrote about In re Brace, in which the Ninth Circuit Court of Appeals asked the California Supreme Court to decide whether the “form of title presumption” trumps the “community property presumption” when spouses take title to real property as joint tenants.  To read our prior post, please click HERE.

On July 23, 2020, in a very thorough decision that will have a big impact on family, bankruptcy, and debtor-creditor law, the California Supreme Court answered the Ninth Circuit’s questions.  The decision can be read HERE.

In sum:  Property acquired by spouses with community funds on or after January 1, 1975, is presumed to be community property even if title to the property is taken in joint tenancy.  The grant deed, in itself, is not sufficient to overcome the community property presumption.  What is required to overcome the community presumption depends on whether the property was acquired before or after January 1, 1985.

Why does it matter when the property was acquired?  In the 1970s, the California legislature enacted landmark reforms to the community property system.  Those reforms, which went into effect on January 1, 1975, eroded prior rules that emphasized the manner in which title was held.  Still, spouses could “transmute” property from community property to separate property (and vice versa) by an oral or written agreement or a common understanding between the spouses.  However, effective January 1, 1985, new legislation provided that a transmutation is not valid unless it is made in writing and satisfies certain requirements.

This decision will have a huge impact in bankruptcy cases, especially chapter 7 cases, in which only one spouse files for bankruptcy.

Consider the following example:  John and Jane own a house that they bought after they were married.  The grant deed says that they took title as “John and Jane, husband and wife, as joint tenants.”  The house is worth $500,000.  Their mortgage is $300,000.  John files a chapter 7 petition, but Jane does not join in.  As is his right, John claims a $75,000 homestead exemption in the property.

Under a 2003 Ninth Circuit case called Summers, the chapter 7 trustee would not sell the house because it would not generate any funds for unsecured creditors.  If she were to sell the house, about $35,000 would go to pay brokerage fees and closing costs, and $300,000 would go to the mortgage company.  That leaves $165,000.  Half of that would be paid to Jane for her one-half joint tenancy interest.  That leaves $82,500.  From that the trustee would pay John his $75,000 homestead exemption.  That leaves $7,500.  The trustee’s statutory fee for selling the property would exceed $7,500.  Since a sale would generate nothing for unsecured creditors, the trustee would “abandon” it back to the debtor.  John and Jane would keep the house, and creditors would receive nothing.

Now, under Brace, the trustee will sell the house because John’s bankruptcy estate includes all community property in which John had an interest when he filed for bankruptcy.  See 11 U.S.C. § 541(a)(2).  After paying costs of sale and the mortgage, the trustee will pay John his homestead exemption and the remaining $90,000 will be used to pay costs of administration (such as the trustee’s fee) and unsecured creditors.  John and Jane will lose the house, and creditors will receive something on account of their claims.

As we predicted in our prior post, the California Supreme Court’s answer will have a significant impact on cases in which only one spouse files for bankruptcy.  In many such cases, the answer makes it more likely that debtors’ houses will be sold and creditors will be paid.