A Subchapter V Debtor’s Eligibility is not Revoked when an Affiliate Subsequently Files for Bankruptcy

Freddy Giovanelli

St. John’s University School of Law

American Bankruptcy Institute Law Review Staff

The families of the victims of the Sandy Hook shooting sued Alex Jones in a Connecticut state court, and his company, Free Speech Systems, in a Texas state court.[1] Before the trials concluded, Free Speech Systems filed for bankruptcy under Subchapter V of Chapter 11 of title 11 of the United States Code (the “Bankruptcy Code”) in the Southern District of Texas.[2] A Subchapter V case differs from a traditional Chapter 11 case in several ways. In particular, a plan under Subchapter V may allow existing shareholders of a debtor to retain their interests in the debtor even where all creditors are not paid in full. In contrast, a plan in a traditional Chapter 11 case is subject to the “absolute priority rule,” pursuant to which creditors must be paid in full for existing shareholders of the debtor to retain their interests. While the Free Speech bankruptcy case was proceeding, a Connecticut state court ordered Jones to pay approximately $1.5 billion in damages.[3] Consequently, Jones separately filed for relief under Chapter 11 in the Southern District of Texas.[4] Three months after Jones filed for bankruptcy, the plaintiffs in the Texas state court case moved to revoke Free Speech Systems’ Subchapter V election, arguing that Free Speech Systems stopped qualifying as a Subchapter V debtor when Jones filed his case.[5] If the court revoked Free Speech Systems’ Subchapter V election, Jones would not be able to retain his interest in Free Speech Systems unless all creditors, including the plaintiffs, were paid in full. Free Speech Systems opposed the plaintiffs’ request, arguing that (i) the court cannot revoke a Subchapter V election because the Bankruptcy Code does not allow a court to revoke the election and (ii) that its Subchapter V eligibility was not affected by Jones’ filing.[6]

Subparagraphs A and B of Section 1182(1) of the Bankruptcy Code list the key eligibility requirements for a Subchapter V debtor.[7] First, under Subparagraph A, a debtor under Subchapter V must have less than $7.5 million in aggregate noncontingent liquidated secured and unsecured debts as of the date of the filing of the petition.[8] Second, under Subparagraph B, a “debtor” would not include any member of a group of affiliated debtors in bankruptcy that has aggregate debts above $7.5 million.[9] According to the plaintiffs, the debtor only needs to comply with Subparagraph A on the petition date because it contains the phrase “as of the date of the filing of the petition”.[10] However, according to the plaintiffs, Subparagraph B is a continuing obligation because it does not contain this phrase.[11]  So, the plaintiffs argue that the debtor lost eligibility when Jones filed for bankruptcy because he is an affiliate of the debtor and his debts exceed $7.5 million.[12] However, the court disagreed and found that the debtor has not lost eligibility.[13]

A debtor that files a petition under Subchapter V must check a box on the petition stating it is a debtor as defined in section 1182(1) of the Bankruptcy Code.[14] Therefore, a debtor must satisfy both prongs, Subparagraphs A and B, on the petition date, but not at a later date.[15] In this instance, there was no dispute that the debtor satisfied both prongs on the petition date.[16] According to the court, a subsequent filing by an affiliate of the debtor does not affect the debtor’s eligibility.[17] The bankruptcy court further found that Bankruptcy Rule 1020(a) requires that a debtor make a statement of election to proceed under Subchapter V, and the case proceeds under Subchapter V unless “the court enters an order finding the debtor’s statement is incorrect.”[18] The debtor’s statement of election was true on the petition date, and the basis for making that statement remains true, so the debtor continues to be eligible under Subchapter V.[19]

Additionally, the Bankruptcy Code and Bankruptcy Rules are silent on how the court should assess a motion to amend a bankruptcy petition to revoke a Subchapter V election.[20] In a different case, the Bankruptcy Court for the District of Columbia held that a judge can designate a Subchapter V case and allow it to proceed as a regular Chapter 11 case if it’s in the best interest of the creditors and the estate.[21] However, that case included five failed Chapter 11 plans, so the court in this case did not find it to be persuasive when deciding against revoking Free Speech Systems’ Subchapter V election.[22] The court held that it is the debtor’s decision to proceed under Subchapter V, and creditors are not free to file motions to move debtors out of Subchapter V whenever they want.[23] For both of these reasons, the court denied the plaintiff’s motion to revoke the debtors Subchapter V election.[24]

Section 1182(1) of the Bankruptcy Code requires that a Subchapter V debtor have less than $7.5 million in debt and that they are not a member of a group of affiliated debtors in bankruptcy that has aggregate debts above $7.5 million. According to the Bankruptcy Court for the Southern District of Texas, a Subchapter V debtor only needs to satisfy the eligibility requirements listed in section 1182(1) on the petition date. Thus, the subsequent filing of an affiliate debtor will not affect the Subchapter V debtor’s eligibility.[25]