Writing in a high-profile case, Bankruptcy Judge Christopher Lopez of Houston wrote an opinion of nationwide significance regarding eligibility to be a debtor under Subchapter V of chapter 11. Recently enacted, Subchapter V was designed by Congress to simplify reorganization for small companies with less than $7.5 million in debt.

In his March 31 opinion, Judge Lopez said that a debtor’s eligibility for Subchapter V is determined as of the filing date.  He ruled that the debtor can’t be kicked out of Subchapter V if an affiliate with too much debt for Subchapter V later files a petition under “ordinary” chapter 11.

If adopted broadly, the opinion means that a family of companies with too much collective debt for Subchapter V may first put one member with less than $7.5 million into Subchapter V and later put other companies into ordinary chapter 11 if there’s too much debt.  The first-filing company could thereby enjoy a simplified route to plan confirmation, while the other members of the group would face the rigors of “ordinary” chapter 11.

The Alex Jones Filings

Radio host Alex Jones gained notoriety for stating on his show that the Sandy Hook school massacre was a hoax. Families of murdered students filed defamation suits in state courts in Connecticut and Texas against Jones and his companies. The defendants defaulted, and default judgments were entered.

Jones owned one of the defendants, Free Speech Systems LLC. It filed a Subchapter V petition in July 2022, before the trial on damages concluded in Connecticut and before the damages trial began in Texas, Judge Lopez said.

Early in the Subchapter V case, Judge Lopez modified the automatic stay to allow the suits to proceed. In October 2022, a Connecticut jury awarded about $1.4 billion. The Texas suit resulted in a judgment of about $50 million.

In December 2022, Jones himself filed a petition under “ordinary” chapter 11 because the judgment gave him more than the $7.5 million cap for Subchapter V.

The Plaintiffs’ Motion to Dedesignate

In February 2023, the plaintiffs filed a motion to revoke the corporate debtor’s Subchapter V status. Rather than dismiss or convert to chapter 7, the plaintiffs wanted the corporate case to continue in “ordinary” chapter 11.

The plaintiffs conceded that the corporate debtor had less than $7.5 million in debt and was eligible for Subchapter V when it filed the original petition, but they contended that the corporate debtor lost eligibility for Subchapter V when Jones filed his own chapter 11 petition. They relied on the eligibility requirements for Subchapter V contained in Section 1182(1)(A) and (1)(B)(i).

On “the date of the order for relief,” Subsection (1)(A) provides that the debtor may have “not more than $7,500,000” in “aggregate noncontingent liquidated secured and unsecured debts.”

Subsection (1)(B)(i) deals with filings by affiliates. It bars a debtor from Subchapter V if it is a “member of a group of affiliated debtors under this title that has aggregate noncontingent liquidated secured and unsecured debts in an amount greater than $7,500,000.”

Judge Lopez said that “a debtor must satisfy both prongs on the petition date” and that “[s]ubparagraphs A and B must be construed together at the same time, all the time.” [Emphasis added.

Judge Lopez found support for his conclusion in Bankruptcy Rule 1020(a), which says that a case proceeds in accordance with the debtor’s election “unless and until” the court rules that the debtor’s election was “incorrect.”

Rule 1020(b) has a challenge period. It provides that an objection to the election must be made “no later than 30 days after the conclusion of the meeting of creditors held under § 341(a) of the Code, or within 30 days after any amendment to the statement, whichever is later.”

The plaintiff’s motion was therefore untimely. Even if it had been filed on time, Judge Lopez said he would have denied “the relief requested . . . for the reasons stated above.”

Judge Lopez found “practical” reasons for a more static view of Subchapter V eligibility. If eligibility were governed by events after filing, “debtors could float in and out of Subchapter V at any time,” he said.

“A roaming eligibility trap,” Judge Lopez said, “could also punish an innocent Subchapter V debtor.” One member of a corporate group, with its own board, could file a petition under Subchapter V, to be undone by a subsequent filing by another member of the group with a different board, “perhaps with unrelated debts.”

Judge Lopez denied the motion to revoke the corporate debtor’s Subchapter V election. However, he ended the opinion by noting that the debtor is not out of the woods. He said there are “several” non-dischargeability adversary proceedings.

With regard to non-dischargeability as to corporate debtors, courts disagree. The Fourth Circuit ruled that corporate debtors in Subchapter V may not discharge debts “of the kind” specified in Section 523(a). Cantwell-Cleary Co. v. Cleary Packaging LLC (In re Cleary Packaging LLC), 36 F.4th 509 (4th Cir. June 7, 2022).

Bankruptcy Judge Craig A. Gargotta of San Antonio disagreed with Cleary and held that “corporate debtors proceeding under Subchapter V cannot be made defendants in § 523 dischargeability actions.” Avion Funding LLC v. GFS Industries LLC (In re GFS Industries LLC), 647 B.R. 337, 344 (Bankr. W.D. Tex. Nov. 10, 2022).

A direct appeal in GFS is pending in the Fifth Circuit.

The outcome of the Fifth Circuit appeal in GFS may determine whether Free Speech Systems can discharge debts to the Connecticut and Texas debtors. If the Fifth Circuit agrees with the Fourth Circuit, the judgments may not be dischargeable.

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